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Chapter+14+Answers+to+end-of-chapter+questions

Chapter+14+Answers+to+end-of-chapter+questions - CHAPTER 14...

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CHAPTER 14 FOREIGN EXCHANGE RISK Chapter outline Sources of Foreign Exchange Risk Exposure Foreign Exchange Rate Volatility and FX Exposure Foreign Currency Trading FX Trading Activities The Profitability of Foreign Currency Trading Foreign Asset and Liability Positions The Return and Risk of Foreign Investments Risk and Hedging Interest Rate Parity Theorem Multicurrency Foreign Asset-Liability Positions Instructor’s Resource Manual t/a Financial Institutions Management 2e by Lange, Saunders, Anderson, Thomson & Cornett 1
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Solutions for end-of-chapter questions QUESTIONS AND PROBLEMS 1. What are the four FX risks faced by FIs? The four risks include (i) trading in foreign securities, (ii) making foreign currency loans, (iii) issuing foreign currency-denominated debt, and (iv) buying foreign currency-issued securities. 2. What is the spot market for FX? What is the forward market for FX? What is the position of being net long in a currency? The spot market for foreign exchange involves transactions for immediate delivery of a currency, while the forward market involves agreements to deliver a currency at a later time for a price or exchange rate that is determined at the time the agreement is reached. The net exposure of a foreign currency is the net foreign asset position plus the net foreign currency position. Net long in a currency means that the amount of foreign assets exceeds the amount of foreign liabilities. 3. X-IM Bank has EUR 14 million in assets and EUR 23 million in liabilities and has sold EUR 8 million in foreign currency trading. What is the net exposure for X-IM? For what type of exchange rate movement does this exposure put the bank at risk? The net exposure would be EUR 14 million – EUR 23 million – EUR 8 million = -EUR 17 million. This negative exposure puts the bank at risk of an appreciation of the Euro against the dollar. A stronger Euro means that repayment of the net position would require more dollars. 4. What two factors directly affect the profitability of an FI’s position in a foreign currency? The profitability is a function of the size of the net exposure and the volatility of the foreign exchange ratio or relationship. 5. The following are the foreign currency positions of an FI, expressed in dollars. Currency Assets Liabilities FX Bought FX Sold Euro (€) $125 000 $50 000 $10 000 $15 000 British pound (£) 50 000 22 000 15 000 20 000 Japanese yen (¥) 75 000 30 000 12 000 88 000 (a) What is the FI’s net exposure in euros? Net exposure in euros = (Assets + FX Bought) – (Liabilities + FX Sold) = $70 000. (b) What is the FI’s net exposure in British pounds? Net exposure in British pounds = $23 000. (c) What is the FI’s net exposure in Japanese yen? Net exposure in Japanese yen = -$31 000. Instructor’s Resource Manual t/a Financial Institutions Management 2e by Lange, Saunders, Anderson, Thomson & Cornett 2
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(d) What is the expected loss or gain if the euro exchange rate appreciates by 1 per cent?
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