Identify, Quantify, and Manage FX Risk
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The Interest Rate Parity (IRP) Is a Theory Regarding the Relationship
What is the Interest Rate Parity (IRP)? The interest rate parity (IRP) is a theory regarding the relationship between the spot exchange rate and the expected spot rate or forward exchange rate of two currencies, based on interest rates. The theory holds that the forward exchange rate should be equal to the spot currency exchange rate times the interest rate of the home country, divided by the interest rate of the foreign country. Uncovered Interest Rate Parity vs Covered Interest Rate Parity The uncovered and covered interest rate parities are very similar. The difference is that the uncovered IRP refers to the state in which no-arbitrage is satisfied without the use of a forward contract. In the uncovered IRP, the expected exchange rate adjusts so that IRP holds. This concept is a part of the expected spot exchange rate determination. The covered interest rate parity refers to the state in which no-arbitrage is satisfied with the use of a forward contract. In the covered IRP, investors would be indifferent as to whether to invest in their home country interest rate or the foreign country interest rate since the forward exchange rate is holding the currencies in equilibrium. This concept is part of the forward exchange rate determination. What is the Interest Rate Parity (IRP) Equation? The covered and uncovered IRP equations are very similar, with the only difference being the substitution of the forward exchange rate for the expected spot exchange rate. The following shows the equation for the uncovered interest rate parity: The following -
An Economic Capital Model Integrating Credit and Interest Rate Risk in the Banking Book 1
WORKING PAPER SERIES NO 1041 / APRIL 2009 AN ECONOMIC CAPITAL MODEL INTEGRATING CR EDIT AND INTEREST RATE RISK IN THE BANKING BOOK by Piergiorgio Alessandri and Mathias Drehmann WORKING PAPER SERIES NO 1041 / APRIL 2009 AN ECONOMIC CAPITAL MODEL INTEGRATING CREDIT AND INTEREST RATE RISK IN THE BANKING BOOK 1 by Piergiorgio Alessandri 2 and Mathias Drehmann 3 In 2009 all ECB publications This paper can be downloaded without charge from feature a motif http://www.ecb.europa.eu or from the Social Science Research Network taken from the €200 banknote. electronic library at http://ssrn.com/abstract_id=1365119. 1 The views and analysis expressed in this paper are those of the author and do not necessarily reflect those of the Bank of England or the Bank for International Settlements. We would like to thank Claus Puhr for coding support. We would also like to thank Matt Pritzker and anonymous referees for very helpful comments. We also benefited from the discussant and participants at the conference on the Interaction of Market and Credit Risk jointly hosted by the Basel Committee, the Bundesbank and the Journal of Banking and Finance. 2 Bank of England, Threadneedle Street, London, EC2R 8AH, UK; e-mail: [email protected] 3 Corresponding author: Bank for International Settlements, Centralbahnplatz 2, CH-4002 Basel, Switzerland; e-mail: [email protected] © European Central Bank, 2009 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 0 Website http://www.ecb.europa.eu Fax +49 69 1344 6000 All rights reserved. -
Interest Rate Risk and Market Risk Lr024
INTEREST RATE RISK AND MARKET RISK LR024 Basis of Factors The interest rate risk is the risk of losses due to changes in interest rate levels. The factors chosen represent the surplus necessary to provide for a lack of synchronization of asset and liability cash flows. The impact of interest rate changes will be greatest on those products where the guarantees are most in favor of the policyholder and where the policyholder is most likely to be responsive to changes in interest rates. Therefore, risk categories vary by withdrawal provision. Factors for each risk category were developed based on the assumption of well matched asset and liability durations. A loading of 50 percent was then added on to represent the extra risk of less well-matched portfolios. Companies must submit an unqualified actuarial opinion based on asset adequacy testing to be eligible for a credit of one-third of the RBC otherwise needed. Consideration is needed for products with credited rates tied to an index, as the risk of synchronization of asset and liability cash flows is tied not only to changes in interest rates but also to changes in the underlying index. In particular, equity-indexed products have recently grown in popularity with many new product variations evolving. The same C-3 factors are to be applied for equity-indexed products as for their non-indexed counterparts; i.e., based on guaranteed values ignoring those related to the index. In addition, some companies may choose to or be required to calculate part of the RBC on Certain Annuities under a method using cash flow testing techniques. -
Revised Standards for Minimum Capital Requirements for Market Risk by the Basel Committee on Banking Supervision (“The Committee”)
A revised version of this standard was published in January 2019. https://www.bis.org/bcbs/publ/d457.pdf Basel Committee on Banking Supervision STANDARDS Minimum capital requirements for market risk January 2016 A revised version of this standard was published in January 2019. https://www.bis.org/bcbs/publ/d457.pdf This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2015. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISBN 978-92-9197-399-6 (print) ISBN 978-92-9197-416-0 (online) A revised version of this standard was published in January 2019. https://www.bis.org/bcbs/publ/d457.pdf Minimum capital requirements for Market Risk Contents Preamble ............................................................................................................................................................................................... 5 Minimum capital requirements for market risk ..................................................................................................................... 5 A. The boundary between the trading book and banking book and the scope of application of the minimum capital requirements for market risk ........................................................................................................... 5 1. Scope of application and methods of measuring market risk ...................................................................... 5 2. Definition of the trading book .................................................................................................................................. -
The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk
The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk By HANNO LUSTIG AND ADRIEN VERDELHAN* Aggregate consumption growth risk explains why low interest rate currencies do not appreciate as much as the interest rate differential and why high interest rate currencies do not depreciate as much as the interest rate differential. Domestic investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rate currency portfolios. Because high interest rate currencies depreciate on average when domestic consumption growth is low and low interest rate currencies appreciate under the same conditions, low interest rate currencies provide domestic investors with a hedge against domestic aggregate consumption growth risk. (JEL E21, E43, F31, G11) When the foreign interest rate is higher than rate currencies, on average, depreciate against the US interest rate, risk-neutral and rational US the dollar when US consumption growth is low, investors should expect the foreign currency to while low foreign interest rate currencies do depreciate against the dollar by the difference not. The textbook logic we use for any other between the two interest rates. This way, bor- asset can be applied to exchange rates, and it rowing at home and lending abroad, or vice works. If an asset offers low returns when the versa, produces a zero return in excess of the investor’s consumption growth is low, it is US short-term interest rate. This is known as the risky, and the investor wants to be compensated uncovered interest rate parity (UIP) condition, through a positive excess return. -
Banking on Deposits: Maturity Transformation Without Interest Rate Risk
THE JOURNAL OF FINANCE • VOL. LXXVI, NO. 3 • JUNE 2021 Banking on Deposits: Maturity Transformation without Interest Rate Risk ITAMAR DRECHSLER, ALEXI SAVOV, and PHILIPP SCHNABL ABSTRACT We show that maturity transformation does not expose banks to interest rate risk— it hedges it. The reason is the deposit franchise, which allows banks to pay deposit rates that are low and insensitive to market interest rates. Hedging the deposit fran- chise requires banks to earn income that is also insensitive, that is, to lend long term at fixed rates. As predicted by this theory, we show that banks closely match the interest rate sensitivities of their interest income and expense, and that this insu- lates their equity from interest rate shocks. Our results explain why banks supply long-term credit. A DEFINING FUNCTION OF BANKS is maturity transformation—borrowing short term and lending long term. This function is important because it sup- plies firms with long-term credit and households with short-term liquid de- posits. In textbook models, banks engage in maturity transformation to earn the average difference between long-term and short-term rates, that is, to earn the term premium. However, doing so exposes them to interest rate risk: an unexpected increase in the short rate increases banks’ interest expense Itamar Drechsler is at the Wharton School, University of Pennsylvania. Alexi Savov and Philipp Schnabl are at New York University Stern School of Business. Itamar Drechsler and Alexi Savov are also with NBER. Philipp Schnabl is also with NBER -
Update on the Insurance Industry's Use of Derivatives and Exposure Trends
2/11/2021 Update on the Insurance Industry's Use of Derivatives and Exposure Trends The NAIC’s Capital Markets Bureau monitors developments in the capital markets globally and analyzes their potential impact on the investment portfolios of US insurance companies. A list of archived Capital Markets Bureau Special Reports is available via the index Update on the Insurance Industry's Use of Derivatives and Exposure Trends The NAIC Capital Markets Bureau published several special reports in the past few years concerning derivatives, providing insight into exposure trends, credit default swaps, hedging, changing reporting requirements, and market developments resulting from enactment of the federal Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and other global initiatives. This report reviews U.S. insurers' derivatives holdings and exposure trends as of year-end 2015. Key Points: Derivatives activity in the U.S. insurance industry leveled off in 2015. The total notional value of derivative positions was virtually unchanged over year-end 2014, at $2 trillion. An overwhelming 94% of total industry notional value pertains to hedging, virtually unchanged since year-end 2010, when the Capital Markets Bureau began analyzing the data. Out of that 94%, 49% pertained to interest rate hedges, same as a year earlier, while 24% pertained to equity risk. Life insurers accounted for approximately 95% of total notional value, compared to 94% at year-end 2014. Property/casualty (P/C) insurers accounted for 5%, down from 6% a year earlier. Derivatives exposure in the health and fraternal segments was minimal, and title insurers reported no exposure. -
Interest Rate Risk Management Page 2
SSTTAANNDDAARRDDSS OOFF SSOOUUNNDD BBUUSSIINNEESSSS PPRRAACCTTIICCEESS IINNTTEERREESSTT RRAATTEE RRIISSKK MMAANNAAGGEEMMEENNTT © 2005 The Bank of Jamaica. All rights reserved Bank of Jamaica March 1996 Interest Rate Risk Management Page 2 INTEREST RATE RISK MANAGEMENT A. PURPOSE This documents sets out the minimum policies and procedures that each institution needs to have in place and apply within its interest rate risk management programme, and the minimum criteria it should use to prudently manage and control its exposure to interest rate risk. Interest rate risk management must be conducted within the context of a comprehensive business plan. Although this document focuses on an institution’s responsibility for managing interest rate risk, it is not meant to imply that interest rate risk can be managed in isolation from other asset/liability management considerations. B. DEFINITION Interest rate risk is the potential impact on an institution’s earnings and net asset values of changes in interest rates. Interest rate risk arises when an institution’s principal and interest cash flows (including final maturities), both on- and off-balance sheet, have mismatched repricing dates. The amount at risk is a function of the magnitude and direction of interest rate changes and the size and maturity structure of the mismatch position. C. INTEREST RATE RISK MANAGEMENT PROGRAMME Managing interest rate risk is a fundamental component in the safe and sound management of all institutions. In involves prudently managing mismatch positions in order to control, within set parameters, the impact of changes in interest rates on the institution. Significant factors in managing the risk include the frequency, volatility and direction of rate changes, the slope of the interest rate yield curve, the size of the interest-sensitive position and the basis for repricing at rollover dates. -
Nber Working Paper Series Common Risk Factors In
NBER WORKING PAPER SERIES COMMON RISK FACTORS IN CURRENCY MARKETS Hanno Lustig Nikolai Roussanov Adrien Verdelhan Working Paper 14082 http://www.nber.org/papers/w14082 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 June 2008 The authors thank Andy Atkeson, Alessandro Beber, Frederico Belo, Michael Brennan, Alain Chaboud, John Cochrane, Pierre Collin-Dufresne, Magnus Dahlquist, Kent Daniel, Darrell Duffie, Xavier Gabaix, John Heaton, Urban Jermann, Don Keim, Leonid Kogan, Olivier Jeanne, Karen Lewis, Fang Li, Francis Longstaff, Pascal Maenhout, Rob Martin, Anna Pavlova, Monika Piazzesi, Richard Roll, Geert Rouwenhorst, Clemens Sialm, Rob Stambaugh, Rene Stulz, Jessica Wachter, Amir Yaron, Hongjun Yan, Moto Yogo and seminar participants at many institutions and conferences for helpful comments. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2008 by Hanno Lustig, Nikolai Roussanov, and Adrien Verdelhan. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Common Risk Factors in Currency Markets Hanno Lustig, Nikolai Roussanov, and Adrien Verdelhan NBER Working Paper No. 14082 June 2008 JEL No. F31,G12,G15 ABSTRACT Currency excess returns are highly predictable and strongly counter-cyclical. The average excess returns on low interest rate currencies are 4.8 percent per annum smaller than those on high interest rate currencies after accounting for transaction costs. -
Foreign Exchange Risk Mitigation for Power and Water Projects in Developing Countries
ENERGY AND MINING SECTOR BOARD DISCUSSION PAPER PAPER NO.9 DECEMBER 2003 Foreign Exchange Risk Mitigation for Power and Water Projects in Developing Countries Tomoko Matsukawa, Robert Sheppard and Joseph Wright THE WORLD BANK GROUP The Energy and Mining Sector Board AUTHORS DISCLAIMERS Tomoko Matsukawa ([email protected]) is Senior Financial Officer of the Project Finance and Guarantees unit The findings, interpretations, and conclusions expressed in of the World Bank. She has worked on various power and this paper are entirely those of the authors and should not be water projects, structuring public-private risk-sharing schemes attributed in any manner to the World Bank, to its affiliated and implementing World Bank guarantee transactions. Prior organizations, or to members of its Board of Executive Directors to joining the World Bank she worked at Morgan Stanley, or the countries they represent. Citicorp and the Chase Manhattan Bank; she holds MBA from Stanford Graduate School of Business. The material in this work is copyrighted. No part of this work may be reproduced or transmitted in any form or by any means, Robert Shepard ([email protected]) is a an independent electronic or mechanical, including photocopying, recording, or consultant working on ways to improve access to capital inclusion in any information storage and retrieval system, without markets for developing country infrastructure projects. the prior written permission of the World Bank. The World Bank He was previously responsible for project finance capital encourages dissemination of its work and will normally grant markets at Banc of America Securities and is a member of permission promptly. -
Speculation and Risk in Foreign Exchange Markets
Chapter 7 Speculation and Risk in the Foreign Exchange Market © 2018 Cambridge University Press 7-1 7.1 Speculating in the Foreign Exchange Market • Uncovered foreign money market investments • Kevin Anthony, a portfolio manager, is considering several ways to invest $10M for 1 year • The data are as follows: • USD interest rate: 8.0% p.a.; GBP interest rate: 12.0% p.a.; Spot: $1.60/£ • Remember that if Kevin invests in the USD-denominated asset at 8%, after 1 year he will have × 1.08 = $10. • What if Kevin invests his $10M in the pound money market, but decides not to hedge the foreign$10 exchange risk?8 © 2018 Cambridge University Press 7-2 7.1 Speculating in the Foreign Exchange Market • As before, we can calculate his dollar return in three steps: • Convert dollars into pounds in the spot market • The $10M will buy /($1.60/£) = £6. at the current spot exchange rate • This is Kevin’s pound principal. $10 25 • Calculate pound-denominated interest plus principal • Kevin can invest his pound principal at 12% yielding a return in 1 year of £6. × 1.12 = £7 • Sell the pound principal plus interest at the spot exchange rate in 1 year 25 • 1 = × ( + 1, $/£) ( + 1) = ( + 1) × ( / ) – (1 + 0.08) • £7 £7 $10 © 2018 Cambridge University Press 7-3 Return and Excess Return in Foreign Market • We can use the previous calculation to deduce a formula for calculating the return in the foreign market, 1 rt( +=1) ×+( 1it( ,£)) × St( + 1) St( ) • The return on the British investment is uncertain because of exchange rate uncertainty. -
Multi-Factor Models and the Arbitrage Pricing Theory (APT)
Multi-Factor Models and the Arbitrage Pricing Theory (APT) Econ 471/571, F19 - Bollerslev APT 1 Introduction The empirical failures of the CAPM is not really that surprising ,! We had to make a number of strong and pretty unrealistic assumptions to arrive at the CAPM ,! All investors are rational, only care about mean and variance, have the same expectations, ... ,! Also, identifying and measuring the return on the market portfolio of all risky assets is difficult, if not impossible (Roll Critique) In this lecture series we will study an alternative approach to asset pricing called the Arbitrage Pricing Theory, or APT ,! The APT was originally developed in 1976 by Stephen A. Ross ,! The APT starts out by specifying a number of “systematic” risk factors ,! The only risk factor in the CAPM is the “market” Econ 471/571, F19 - Bollerslev APT 2 Introduction: Multiple Risk Factors Stocks in the same industry tend to move more closely together than stocks in different industries ,! European Banks (some old data): Source: BARRA Econ 471/571, F19 - Bollerslev APT 3 Introduction: Multiple Risk Factors Other common factors might also affect stocks within the same industry ,! The size effect at work within the banking industry (some old data): Source: BARRA ,! How does this compare to the CAPM tests that we just talked about? Econ 471/571, F19 - Bollerslev APT 4 Multiple Factors and the CAPM Suppose that there are only two fundamental sources of systematic risks, “technology” and “interest rate” risks Suppose that the return on asset i follows the