Drake DRAKE UNIVERSITY Fin 286 International Risk Management.

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Drake DRAKE UNIVERSITY Fin 286 International Risk Management
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Transcript of Drake DRAKE UNIVERSITY Fin 286 International Risk Management.

DrakeDRAKE UNIVERSITY

Fin 286

International Risk Management

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Fin 286Introduction

This portion of the class covers portions of three different chapters in the book, chapters 15, 16 and 23. This issue has become increasingly important for FIs due to hedging needs and speculative positions taken to increase income.

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Fin 286Background

Globalization of financial markets has increased foreign exposure of most FIs.FI may have assets or liabilities denominated in foreign currency (in addition to direct positions in foreign currency).Foreign currency holdings exceed direct portfolio investments.

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Fin 286Sources of FX Risk

Spot positions denominated in foreign currencyForward positions denominated in foreign currencyNet exposure in currency i = (FX assetsi - FX liabi) + (FX boughti - FX soldi)

Net long (+)Net Short (-)

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Fin 286FX Risk Exposure

Could match foreign currency assets and liabilities to hedge F/X risk, but that is not enough

Must also hedge against foreign interest rate risk (by matching durations, for example)

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Fin 286Trends in FX

Value of foreign positions has increasedVolume of foreign currency trading has decreasedCauses:

Investment bank mergersIncreased trading efficiency through technological innovationIntroduction of the euro

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Fin 286FX Risk Exposure

Greater exposure to a foreign currency combined with greater volatility of the foreign currency implies greater DEAR.Dollar loss/gain in currency i = [Net exposure in foreign currency i measured in U.S. $] × Shock (Volatility) to the $/Foreign currency i exchange rate

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Fin 286FX Trading

FX markets turnover often greater than $1.8 trillion per day. The market moves between Tokyo, NYC and London over the day allowing for what is essentially a 24-hour market. Overnight exposure adds to the risk.

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Fin 286Trading Activities

Basically 4 trading activities:Purchase and sale of currencies to complete international transactions.Facilitating positions in foreign real and financial investments.Accommodating hedging activitiesSpeculation.

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Fin 286Profitability of FX Trading

For large US banks, trading income is a major source of income.

Volatility of European currencies are declining (due to euro)Volatility in Asian and emerging markets currencies higherRisk arises from taking open positions in currencies

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Fin 286Foreign Assets & Liabilities

Mismatches between foreign asset and liability portfoliosAbility to raise funds from internationally diverse sources presents opportunities as well as risks

Greater competition in well-developed (lower risk) markets

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Fin 286Return and Risk of

Foreign Investments

Returns are affected by:Spread between costs and revenues changes in FX rates

Changes in FX rates are not under the control of the FI

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Fin 286Risk and Hedging

Hedge can be constructed on balance sheet or off balance sheet.

On - balance-sheet hedge will also require duration matching to control exposure to foreign interest rate risk.Off-balance-sheet hedge using forwards, futures, or options.

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Interest Rate Parity Theorem

Equilibrium condition is that there should be no arbitrage opportunities available through lending and borrowing across currencies. This requires that 1+r(domestic) = (F/S)[1+r (foreign)]

Difference in interest rates will be offset by the expected change in exchange rates.

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Fin 286Multicurrency Positions

Since the banks generally take positions in more than one currency simultaneously, their risk is partially reduced through diversification.Overall, world bond markets are significantly, but not fully integrated which leaves open the opportunity to reduce exposure by diversifying.

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Diversification Effects (continued)

High correlations between the bond returns may be due to high correlation of real interest rates over time and/or inflation expectations.

ri = rri + iei

Nominal return = real return + E[inflation]

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Fin 286Sovereign Risk (chapter 16)

In 1970s:Expansion of loans to Eastern bloc, Latin America and other LDCs.

Beginning of 1980s:Poland and Eastern bloc repayment problems.Debt moratoria announced by Brazil and Mexico.Increased loan loss reserves

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Fin 286Introduction (continued)

Late 1980s and early 1990s:Expanding investments in emerging markets.Peso devaluation.

More recently:Asian and Russian crises.MYRAsBrady Bonds

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Fin 286

Credit Risk versus Sovereign Risk

Sovereign Risk -- Governments can impose restrictions on debt repayments to outside creditors.

Loan may be forced into default even though borrower had a strong credit rating at origination of loan.Legal remedies are very limited.

Need to assess credit quality and sovereign risk

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Fin 286Sovereign Risk

Debt repudiation – cancellation of current and future debt obligations

Since WW II, only China, Cuba and North Korea have repudiated debt.

Rescheduling –moratorium or delay in payments of a country or group of creditors in a country

Most common form of sovereign risk.

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Fin 286Debt Rescheduling

More likely with debt financing rather than bond financingLoan syndicates often comprised of same group of Fis probability of agreement increasesCross-default provisions state that one default constitutes default in entire portfolioSpecialness of banks argues for rescheduling but, incentives to default again if bailouts are automatic

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Fin 286Country Risk Evaluation

Outside evaluation models:The Euromoney IndexThe Economist Intelligence Unit ratings – higher the rating greater the risk

Based upon both economic and political risks.

Institutional Investor Index

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Fin 286Country Risk Evaluation

Internal Evaluation Models Statistical models:

Country risk-scoring models based on primarily economic ratios.

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Fin 286Statistical Models

Commonly used economic ratios:Debt service ratio: (Interest + amortization on debt)/ExportsImport ratio: Total imports / Total FX reservesInvestment ratio: Real investment / GNPVariance of export revenueDomestic money supply growth

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Fin 286

Problems with Statistical CRA Models

Measurements of key variables.Population groups

Finer distinction than reschedulers and nonreschedulers may be required.

Political risk factorsStrikes, corruption, elections, revolution.

Portfolio aspects

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Fin 286

Problems with Statistical CRA Models (continued)

Incentive aspects of rescheduling:Borrowers and Lenders:

BenefitsCosts

StabilityModel likely to require frequent updating.

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Fin 286

Mechanisms for Dealing with Sovereign Risk Exposure

Debt-equity swapsExample:

Citibank sells $100 million Chilean loan to Merrill Lynch for $91 million.Merrill Lynch (market maker) sells to IBM at $93 million.Chilean government allows IBM to convert the $100 million face value loan into pesos at a discounted rate to finance investments in Chile.

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Fin 286

Multi Year restructuring agreements MYRAs

Aspects of MYRAs:Fee charged by bank for restructuringInterest rate chargedGrace periodMaturity of loanOption features

Concessionality

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Fin 286Other Mechanisms

Loan SalesBond for Loan Swaps (Brady bonds)

Transform LDC loan into marketable liquid instrument.Usually senior to remaining loans of that country.

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Fin 286

Geographic Diversification Chapter 23

Although many FIs can diversify domestically, the benefits to global diversification are available only to large firms. This chapter explores the potential risk-return advantages and disadvantages of international expansion and the trends toward globalization of FI franchises. As countries such as the U.S. expand, some countries, Japan in particular, are contracting their overseas operations.

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Fin 286

Global and International Expansions

Three ways to establish global presenceSell financial services from domestic offices to foreign customersSell financial services through a branch, agency, or representative office in foreign customer’s countrySell financial services through subsidiary company in foreign customer’s country.

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Fin 286Global Expansion of FIs

U.S. insurance companies and securities firms recent expansion12 banks in the world with over 50 percent of assets in foreign countries

No single country dominatesJapanese banks absent in spite of their size

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Fin 286U.S. Banks Abroad

J.P. Morgan/Chase have had offices abroad since beginning of century.

Major growth began in 1960sOverseas Direct Investment Control Act, 1964.Offshore funding and lending in dollars forged beginnings of the Eurodollar market.Assets of U.S. bank activities abroad increased from $353.8 billion in 1980, to $745 billion in 2001. Declined in percentage terms.

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Fin 286

Factors Encouraging U.S. Bank Expansions Abroad

Dollar as international medium of exchangeEffects of Euro

Political riskEncouraged flows to U.S. branches and subsidiaries in Cayman Islands and Bahamas.USA Patriot Act of 2001 prohibited services to shell banks and increased focus on money laundering

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Fin 286

Factors Encouraging U.S. Bank Expansions Abroad

Domestic activity restrictionsFed regulations permitting banks to engage in activities permitted by foreign host.

Diversification benefits.

Technology and communications improvements

CHIPSDecreasing operating costs

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Fin 286Factors Deterring Expansion

Capital constraintsBIS 2001 reforms raise capital requirements for loans to non-OECD sovereigns rated below B-raise capital requirements for loans to OECD countries rated below AA-zero risk weights for OECD countries rated above AA-

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Fin 286Factors Deterring Expansion

Emerging markets problemsIncreased caution due to Korea, Thailand, Indonesia despite improved regulatory environment (NAFTA, for example).WTO reduction of barriers to global expansion

China as a recent noteworthy example

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Fin 286Factors Deterring Expansion

CompetitionDuring 1990s, extensive competition from Japanese banksJapan had 9 of the 10 largest banksEuropean Community Second Banking Directive resulted in significant consolidation of European banks.

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Fin 286Foreign Banks in the U.S.

Organizational formSubsidiaryBranchAgencyEdge Act CorporationRepresentative Office

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Fin 286Trends and Growth

Rapid expansion of foreign banks in U.S.In 1980, foreign banks had assets of $166.7 billion (10.8 percent of total U.S. bank assets)1992, $514.3 billion (16.4 percent)1994, $471.1 billion (13.8 percent)Retrenchments due to several factors including competitive and regulatory effects.Recent growth in foreign bank operations in U.S.

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Fin 286

Regulation of Foreign Banks in U.S.

Prior to 1978, foreign branches and agencies were licensed mostly at state level.

No access to discount windowNo direct access to Fedwire/fed funds marketsNo FDIC coverage

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Regulation of Foreign Banks in U.S. (post 1978)

Passage of International Banking Act, 1978

National treatment to level the playing fieldAccelerated expansion of foreign banks in U.S.Japanese bank entry into California, and subsequent sales notable

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Fin 286Regulation of Foreign Banks

Foreign Bank Supervision Enhancement Act 1991, increased federal control.

Triggered by three events:collapse of BCCIissuance of $1 billion in unauthorized letters of credit to Iraq by Atlanta agency of Banca Nazionale del Lavorounauthorized taking of deposit funds by U.S. representative of Greek National Mortgage Bank of New York.

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Fin 286Features of FBSEA

Fed’s approval required for entryClosure under control of Federal Reserve

Daiwa Bank ordered to cease operations.

Examination by FedDeposits: Only foreign subsidiaries with FDIC coverage can take deposits under $100,000.Activity powers: restricted to activities permitted to federal branch.

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Fin 286

Advantages to International Expansion

Risk diversificationEconomies of scaleInnovations

generate extra returns from selling new products abroad.

Funds sourceCustomer relationshipsRegulatory avoidance

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Fin 286Disadvantages

Information/monitoring costsExample: differences in accounting standards

Nationalization/expropriation.Fixed costs may be high

Tokyo real estate prices for example.