Exam 13: Foreign Exchange Risk

Your U.S. bank issues a one-year U.S. CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar) investment in two-year, fixed rate Canadian bonds selling at par and paying 7 percent annually. You expect to liquidate your position in one year. Currently, spot exchange rates are US $0.78493 per Canadian dollar. -If you wanted to hedge your bank's risk exposure, what hedge position would you take?

Violation of the interest rate parity theorem would allow arbitrage profits.

On-balance-sheet hedging involves making changes in the on-balance-sheet assets and liabilities to protect FI profits from FX risk without the use of derivative securities.

An FI can eliminate its currency risk exposure by matching its foreign currency assets to its foreign currency liabilities.

What is the portfolio weight of the Euro in this FI's portfolio of foreign currency?

The spot foreign exchange market is where forward and futures contracts and swap agreements are transacted.

An FI has purchased (borrowed) a one-year $10 million Eurodollar deposit at an annual interest rate of 6 percent. It has invested these proceeds in one-year Euro (€) bonds at an annual rate of 6.5 percent after converting them at the current spot rate of €1.75/$. Both interest and principal are paid at the end of the year. -What is the spread earned by the bank at the end of the year if the exchange rate remains at €1.75/$?

During 2012, the top four banks that operate in foreign currency trading comprised almost half of the market.

A positive net exposure position in FX implies the FI is net short in a currency.

An FI can control its FX risk exposure by on-balance-sheet and off-balance-sheet hedging.

What is the end of year profit or loss on the bank's cash position if in one year both Canadian bond rates increase to 7.538 percent and the exchange rate falls to US $0.765 per Canadian dollar? (Assume no change in U.S. interest rates.)

A positive net exposure position in FX implies an FI has purchased more foreign currency than it has sold.

When purchasing and selling foreign currencies to allow customers to take positions in foreign real and financial investments, the FI

As of March 2012, U.S. banks were net short British pounds.

What is the portfolio weight of the Japanese yen in this FI's portfolio of foreign currency?

The FX markets of the world have become one of the largest of all financial markets.

During the late 2000's financial crisis, global stock market return correlations decreased relative to the decade before the crisis.

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom. -If the exchange rate had fallen from $1.60/≤1 at the beginning of the year to $1.50/≤1 at the end of the year when the FI needed to repatriate the principal and interest on the loan. What would be the dollar loan amount repatriated at the end of the year?

Assume that instead of investing in Euro bonds at a fixed rate of 6.5 percent, it invests them in variable rates of LIBOR + 1.5 percent, reset every six months. The current LIBOR rate is 5 percent. What is the annual spread earned by the bank if LIBOR at the end of six months is 5.5 percent? Assume both interest and principal will be reinvested in six months. Assume the exchange rate remains at €1.75/$ at the end of the year.

In which of the following FX trading activities does the FI not assume FX risk?