Exchange Credit Risk: Measurement and Implications on the Stability of Partially Dollarized Financial Systems

Abstract

Some emergent economies present a high financial dollarization both in loans and deposits. This generates a specific risk in the banking activity. The exchange credit risk is defined as the expected loss resulting of a loan in foreign currency taken by an agent who receives its income in local currency. The purpose of this paper is to quantify this risk as the price of an option in a portfolio equivalent to this loan, and also to discuss the implications on the financial stability due to the (implicit) issuance of these options by the banks. In general terms, we argue that the aggregate risk resulting from this risk diminishes with the development of a derivative market where the underlying is the exchange rate. In particular, it is argued that options are preferable to forwards by reasons of cost, accessibility and because they adapt better to the debtor’s needs. In order to price options the exchange rate is modeled through a L evy process. The depth of the market considered in the pricing process depends on the type of the currencies involved. The best situation is to depart from option prices, then to calibrate a model, and afterwards to obtain option prices for the strikes and exercise times needed. This is the case of the EUR/USD market. But if the market is not liquid, as it’s the USD/UYU market, the lack of option prices raises the need of providing alternative pricing methodologies. The chosen methodology consists in estimating the historical probability departing from exchange rate prices, obtaining a risk neutral measure with the help of the Esscher transform. This second methodology is also applied to the EUR/USD case in order to compare the results.