Currency Assets Research Articles

Optimal currency hedge ratios and interest rate risk

The objective of this article is to provide a framework for the interpretation of the optimal currency hedge ratios on foreign investments, taking into account interest rate risk. This is made possible by using a continuous-time setting in the spirit of Merton (1969). We focus on the importance of the interest rate differential (forward basis) in setting the optimal currency hedge because of the influence of interest rates on exchange rates. More specifically, we consider two discount bonds, a domestic and a foreign one, which follow stochastic processes possibly correlated with the other state variables of the model. It is shown that the optimal hedge ratio can be split into five components: (a) a ‘macro-economic’ component which is a function of the volatility of the interest rate differential and its covariance with currency movements; this term depends on the currency considered but not on the asset being hedged; (b) an ‘asset-specific’ term which is directly related to the covariance of the foreign currency asset return with exchange and interest rate movements; (c) a ‘speculative’ term function of the investor's risk preference and of the conditional risk premium on the exchange rate, and (d) two stochastic opportunity set hedging terms. The analysis of the optimal hedge ratio is illustrated on the period December 1970–1989 for stock and bond investments in seven countries. (JEL G15, F31)

ECU interest rates and ECU basket adjustments: An arbitrage pricing approach

This paper considers arbitrage pricing of bonds and the determination of interest rates in the European Currency Unit (ECU) in situations of impending ECU basket adjustments. These adjustments disrupt the markets for private ECU assets with a lead of several months. The approach of the paper is based on the observation that the ECU is a derivative asset so that in the absence of transaction costs prices of ECU denominated assets should be determined by the prices of the existing member currency assets and the member currencies' exchange rates. Using the technical apparatus of arbitrage pricing theory it is shown how the fundamental arbitrage pricing relationships implied by the derivative character of the ECU have to be adjusted in order to be applicable during periods of ECU basket adjustments.

The Determinants of the Growth of Multinational Banking Organizations: 1972-86

The paper develops an empirical model to explain growth of total assets of a sample of the world's largest banks. The model was estimated over a period in which U.S. banks' assets grew less rapidly than the assets of large banks headquartered in other industrial countries. The model provides an estimate of the banks' allocation between home currency and foreign currency assets which allows an estimate of the impact of exchange rate exchanges on bank asset growth.The results of the model suggest that no single economic variable explains the faster growth of non-U.S. banks. Changes in real exchange rates were estimated to have had a significant impact on bank asset growth through their impact on the dollar value of banks' home-currency assets. This impact was greater over a shorter time period when exchange rate movements tended to be larger. Over the longer run other factors, such as faster home-country economic growth, an expanding trade and foreign investment sector, and the ability of large banks to retain their share of domestic intermediation, tended to be relatively more important.The model tested whether banks headquartered in particular countries tended to respond in a similar manner to economic variables and could be aggregated into a single behavioral equation. Aggregation was generally indicated for non-U.S. banks and was rejected for American banks. The model overpredicted asset growth for large U.S. and Canadian banks after 1982, suggesting that various factors including pressure by bank regulators to increase capital ratios and asset quality questions may have affected their asset growth sooner than banks headquartered in other countries.

Managing Foreign Exchange Risks: Organisational Aspects

A multinational firm in its normal, day to day conduct of business becomes vulnerable to potential gains and losses due to changes in the values of its assets and liabilities that are denominated in foreign currencies. Exporting, importing, and investing abroad expose the firm to foreign exchange risks. Under the 1944 Bretton Woods Agreement, Central Bank interventions in foreign currency markets were frequent, with relatively minor changes in exchange rates. Managers then could afford to ignore foreign exchange exposure. However, with the demise of the Agreement in 1973, exchange rates for major currencies have fluctuated freely, sometimes wildly. These currency fluctuations constantly change the values of foreign currency assets and liabilities, thereby creating foreign exchange risks. Managing these foreign exchange risks now constitutes one of the most difficult and persistent problems for financial managers of multinational firms.

Dynamic stability of portfolio balance models of the exchange rate

The conditions for stability of a portfolio balance model of exchange rate determination with an endogenous current account are examined for various expectational assumptions. It is shown that unless strongly stabilizing expectational assumptions are made, if the economy is a net debtor in foreign currency assets there is the possibility that its exchange rate will exhibit instability.

Decision Analysis for Exchange Risk Management

One of the factors which complicates financial decision making in a multinational enterprise is currency devaluations or revaluations in countries where subsidiaries are located. Since exchange rate changes affect the reported earnings, value of financial assets, and future earnings of the multinational corporation, it is imperative that the financial decision maker of such a firm develop a strategy to manage the foreign exchange risk assumed by the firm. It is the purpose of this article to develop relatively formal decision rules for managing the risk of exchange rate change. These rules are based on an analysis of a theoretical decision model of the exchange management process. The inherent uncertainty involved in exchange rate movements is the basic feature of the exchange risk situation. The nature of an optimal decision thus will depend on the attitudes of management toward risk and uncertainty. Four common attitudes will be assumed and examined: minimum variance, minimax, expected monetary value, and expected utility. Each yields a particular set of optimal rules for exchange risk adjustment. Three techniques are available for adjusting the exchange risk posture of the firm. These are (1) adjustment of funds flows, (2) forward contracts, and (3) exposure netting. Adjustment-of-funds-flow techniques involve an alteration in the planned funds flows of parent and/or subsidiaries, in amount and/or currency of denomination, with the view of reducing (or increasing) the local currency accounting exposure of the corporation. This exposure is defined as the difference in local currency assets translated to domestic currency at the current exchange rate and local currency liabilities translated at the same exchange rate. If the objective of management is to decrease exposure, the technique must increase local currency denominated liabilities or decrease local currency denominated assets. Techniques for increasing liabilities include local borrowing and stretching payables. Techniques for decreasing assets include reduction of cash balances and other liquid assets, reduction in investment in accounts receivable (either by tightening credit terms or factoring), and reduction in inventory investment (if inventories are translated at the current exchange rate). Each of these techniques generates local currency funds. If exposure is to be reduced, these funds must be used to acquire assets which are not exposed to the exchange risk. For example, if the parent corporation had planned to provide domestic currency funds to the subsidiary, locally generated funds can replace funds from the parent. Alternatively,

The Educational Campaign for Banking Reform

RGANIZING the National Citizens League in 1911 was no less a task than organizing the country. It was the final step, outside of political declaration and legislative action, to bring about a demand for the reform of the nation's banking laws. The havoc of the last panic had been wrought. Emergency legislation in the form of the AldrichVreeland Act was on the Statute Books. The Monetary Commission had junketed, experted and ruminated and Senator Aldrich was working on a reform proposal. From these statements it might be gathered that public sentiment had at least begun to crystallize; that the subject of all this discussion and effort was nearing the point of issue and action. Nothing was farther from the truth. There was no popular comprehension of what it was all about. Panic meant only a lack of currency. Newspaper writers were miles at sea. Politicians were floundering in darkness. Practical bankers were looking to their few leaders for guidance. The economists, however clear their theories, were blinded by traditions. and precedents of long standing. There was a dominant desire for a change but any suggestion of a practical plan raised a clamor of hostility to centralization, the great political bugaboo. The persistence of political rancor found a new demonstration every time a central bank or the centralization of banking power was mentioned The traditions of the Democratic party stood as strongly in this respect as when Andrew Jackson and Nicholas Biddle fought over the Second Bank of the United States eighty years before. The mention of asset currency roused the smoldering fires of greenbackism and free silverism. It was plain that many people cherished the belief that issuing currency w s a sovereign power of the governme t, and Mr. Bryan was present to insist that such was the case.