the Swiss franc and euro, for example, theexchange rate has in practice remained within a range of 1.40 to1.80 (or the previous equivalent against the Deutschemark) forvery many years.• Crawling peg/adjustable peg Under a crawling peg system, thepar value of a currency relative to some other currency is adjustedregularly – often monthly. The par value and rate of adjustmentare determined with reference to some measure of the externalstrength of a currency such as inﬂation differentials with othercountries. The policy on exchange rate adjustments is announcedin advance, so that it provides some measure of certainty.An adjustable peg is similar to a crawling peg, except thatthe adjustments are on more of an ad hoc basis, rather thanpredetermined. The Egyptian pound is managed on an adjustablepeg against the US dollar.The European ERM (see below) has been in practice a hybridbetween a dirty ﬂoating system and an adjustable peg, wherebythe exchange rates have been maintained by the governmentswithin limits around par values value with respect to eachother.• Basket arrangements Some currencies are managed under aﬁxed regime or on a crawling peg, but against an average basketof currencies rather than against a single currency, where thecurrencies in the basket are weighted according to their importance in the country’s international transactions.The SDR (special drawing right) – the artiﬁcial accountingcurrency of the IMF – is itself a basket currency, composed ofﬁxed amounts of US dollars, euro, sterling and yen.• Dual rates One means of controlling speculation against acurrency is a system of multiple exchange rates, whereby therate for the currency is differentiated according to the type oftransaction.
Currency relationships
185
European Monetary UnionThe European monetary systemThe European monetary system (EMS), launched on 13 March 1979,grouped together the currencies of eight European countries. TheEMS included a mechanism for enabling currency adjustments totake place in an orderly way – the exchange rate mechanism (ERM).This was built around the ECU, a basket currency composed ofdifferent weightings of the national currencies.The EMS also represented the initial phase of European monetaryand economic integration. The system’s original goals were:• To facilitate exchange rate stability in order to foster monetaryand price stability as well as intra-European trade and thereby topromote economic integration within the European Union (EU).• To put the responsibility for correcting policies on governmentsasking for changes in exchange rate parities. For example, agovernment seeking a devaluation of its currency was obligedto tighten monetary and/or ﬁscal policies to reduce economicimbalances.• To facilitate the eventual creation of a European currency – nowthe euro.In line with these aims, each member country had to reduce pressure on its currency when it became apparent that its economicpattern was diverging from other members’ economies and creatingproblems in the foreign exchange market. The action might beincreased intervention in the foreign exchange market, a changein economic policies, or a devaluation or revaluation of the currency.From January 1987 to 1992, there were no revaluations or devaluations of any member currencies except for devaluations of the lira.This was essentially because no government wished to be seen ashaving a weak economy and currency. There were nevertheless significant economic divergences between the economies and pressurestherefore built on the ERM. By September 1992, market speculation was sufﬁcient to force the lira and sterling to leave the ERM(the alternative would have been to devalue massively) – although thelira rejoined in November 1996. By August 1993, speculation forceda more general readjustment of the currencies. The governmentsconcerned still did not wish to be seen as giving in to the markets,however. The EU chose to avoid the issue by widening the ERM bandsfrom ±2.25% as they then were for most currencies (±6% for ESPand PTE) to ±15% for all currencies. The result was bands so wide
186
Foreign exchange and money markets
that there was little incentive for the market to speculate against anymember currency. This begged the question of whether a system withsuch tolerant limits was in fact a system at all, and remained thesituation until European Monetary Union (EMU ) in 1999.
EMU and the euroThe Maastricht Treaty of 1991 set out a three-stage path towardsmonetary union. The ﬁrst stage, already begun in mid-1990, involvedthe easing of restrictions on capital movements and closer economicpolicy co-ordination. The second stage, started at the beginning of1994, established a European Monetary Institute (EMI) in Frankfurt to pave the way for transition to the ﬁnal stage through closeralignment or convergence of the economic policies and the economiesof the member states. The EMI was replaced in July 1998 by theestablishment of a European Central Bank (ECB).The third and ﬁnal stage was the introduction of a single currency,the euro, at the beginning of 1999. In order to provide benchmarksfor economic soundness, there were ﬁve convergence criteria whichshould have been met or approached in 1997 by countries intendingto participate:(i) The country’s general government budget deﬁcit should be nomore than 3% of GDP.(ii) The country’s total general government debt outstanding shouldbe no more than 60% of GDP, or approaching that level satisfactorily.(iii) Consumer price inﬂation should be no more than 1.5% higherthan the average of the inﬂation in the three countries with thelowest inﬂation.(iv) Long-term government bond yields should be no more than 2.0%higher than the average of the long-term interest rates of thesame three countries as in (iii).(v) The country’s exchange rate must have been maintained withinthe ‘normal ﬂuctuation bands’ for 2 years prior to joining.The 12 EMU currenciesFollowing this process, it was determined on 2 May 1998 which elevencurrencies would join the euro on 1 January 1999, and at what ﬁxedexchange rates against each other. These rates were in fact the samecentral ERM cross-rate parities then prevailing. On 31 December1998, the rates were announced at which each of these currencieswas then ﬁxed irrevocably against the euro. This rate depended partlyon the 2 non-EMU components of the ECU – sterling and the Danish
Currency relationships
187
krone (the drachma and the Swedish krona were not in the ECUbasket).The Greek drachma joined the euro subsequently, on 1 January2001.The 12 national currency units or legacy currencies continued toexist, but only as units of the euro, until early 2002.The irrevocably ﬁxed rates of the legacy currencies against the eurowere set at the following:
Fixed rate against the euroAustrian SchillingBelgian francFinnish markkaFrench francDeutschemarkIrish poundItalian liraLuxembourg francDutch guilderPortuguese escudoSpanish pesetaGreek drachma
13.760340.33995.945736.559571.955830.7875841936.2740.33992.20371200.482166.386340.750
ERMIIThe EU countries not joining EMU in 1999 were Denmark, Greece,Sweden and the UK. Of these currencies, the Danish krone and theGreek drachma transferred from the former ERM to a new ERMII.Under the rules of ERMII, the member currencies (now only thekrone) must be kept within an agreed band around an agreed centralrate against the euro. In the case of the krone, the band is ±2.25%.As with the original ERM, once a currency is in danger of breachingits bands, the government concerned is obliged to do one of thefollowing:• Intervene directly in the foreign exchange market to strengthen orweaken the currency. All governments may support the intervention, but the onus is on the government of the currency involved.• Adjust economic policy to affect currency market perceptions. Forexample, the government of a weak currency might raise interestrates to make the currency more attractive.• Revalue or devalue the central rate against the euro.
188
Foreign exchange and money markets
Analysing currency movementsOverviewThis book does not attempt to provide a recipe for forecastingexchange rates. Rather, this is a very brief look at the framework inwhich forecasts are developed. There are essentially 2 very differentapproaches.
Technical analysisOne approach is technical analysis or charting. In its purest form, thisdepends entirely on examining past price movements and ignoringany outside factors which the forecaster may anticipate. An importantprinciple of technical analysis is that the current price already reﬂectsall known factors, as they have been absorbed into past price movements by market participants. There is no value in superimposingfurther factors and the chartist’s forecast is therefore generatedentirely from past price patterns.By careful observation of price, volume and open interest andmathematical analysis of patterns in the price movement, the chartistconstructs a picture that reﬂects existing investor sentiment andpsychology and hence how investors view the market. On this basis,future price movements are forecast.
Fundamental analysisThe second approach is to assume that the forecaster can validlyanticipate changes in outside factors and that he should do so andbase his forecast on these. This is termed fundamental or judgmentalforecasting. The forecaster must use his judgement in assessingwhich factors are important, how these factors will develop, and whateffect they will have on the price being forecast. For example: areworld political developments likely to have an effect on the EUR/USDexchange rate? If so, what are these developments expected to be? Willthese developments have a positive or negative effect on the exchangerate? The answers to these questions can all change over time. RisingUS interest rates, for example, have, at different times in the past, hada strongly negative effect on the US dollar, a strongly positive effect,and no effect at all. The fundamental approach can be considered inseveral stages – long-term, medium-term and short-term.Technical analysis assumes that the current price alreadyreﬂects all known factors and that future price movementscan be forecast on the basis of past price patterns.
Currency relationships
189
Fundamental analysis assumes that the forecaster can validlyanticipate changes in outside factors and that future price movements can be forecast on the basis of these changes.The long-term view – purchasing power parityFundamentally, in a free market, an exchange rate is the mechanism by which prices of goods in different countries are equated.Assume that identical goods, freely tradeable, are obtainable fromeither country A or country B. If I am in country C, I am concernedonly with the price to me in my own currency of buying from either Aor B. If the prices are the same when converted into my own currency,then the exchange rate between A and B is at a fair level in relationto these goods. Suppose that over the next ten years, inﬂation incountry A is much higher than in country B, so that the price of thegoods rises much faster in A than in B. If the A/B exchange ratedoes not change, I will buy only from B, not from A. To overcome thislack of competitiveness in country A, the exchange rate must moveover the ten years in such a way as to take account of the inﬂationdifferential. This is the purchasing power parity (PPP) concept.
PPP is the idea that a currency’s exchange rate must move, inthe long term, to adjust for inﬂation differentials against othercountries.This theory can sometimes be seen to function reasonably well inthe very long run. In the short and medium term, however, it isgenerally a poor indicator of currency movements. There are severaldifﬁculties with it:• Many goods are not internationally tradeable. The prices of ahaircut, a mortgage or local fresh food may be important parts ofinﬂation as measured, but have no bearing on international trade.Ideally, a measure of inﬂation is needed which only measuresinternationally traded goods.• In practice, most goods are not identical in different countries.Even when they are, other factors such as product quality, deliverytime, credit terms, prestige, after-sales service, reliability, prejudice etc. may affect the extent to which one country can sell itsgoods more easily than another.• Price differentials may be maintained by tariff and trade controls,transportation costs, different national resources, or technologicalinnovations.
190
Foreign exchange and money markets
• Price equalization cannot, in practice, hold for individual goods.One test is to compare a country’s domestic prices for a rangeof goods with a weighted average of prices for similar importedproducts.• Once a country has a balance of payments deﬁcit, its exchangerate may need to be even weaker than implied by purchasingpower parity in order to redress the balance. This gives rise to theconcept of a Fundamental Equilibrium Exchange Rate (FEER). Thisis the rate which is necessary in order to achieve a sustainablebalance in the country’s external current account.Figures 11.2 and 11.3 show two examples. In both cases, the inﬂation differential used is based on producer price indexes (German PPI÷ US PPI and German PPI ÷ UK PPI respectively). The GBP/DEMdemonstrates a reasonably good long-term correlation between thecurves. The USD/DEM is reasonable in the very long term butdramatically wrong in the short term. In the case of Germany, theexchange rate has been expressed against the Deutschemark ratherthan the euro, as the Deutschemark was the currency for most of theperiod. From 1999 onwards, the euro rate has been converted at theﬁxed EUR/DEM parity.3.50USD/DEMexchange rate3.00
2.50Relative producer price inflation2.00
1.50
1.001/73 1/75 1/77 1/79 1/81 1/83 1/85 1/87 1/89 1/91 1/93 1/95 1/97 1/99 1/01
Figure 11.2 Purchasing power parity for USD/DEM.
The medium-term viewThere are very many factors which can affect an exchange rate inthe medium term including, for example, economic growth, monetary
Currency relationships
191
9.008.00
Relative producer price inflation
7.006.005.004.003.00
GBP/DEMexchange rate
2.001.001/73 1/75 1/77 1/79 1/81 1/83 1/85 1/87 1/89 1/91 1/93 1/95 1/97 1/99 1/01
Figure 11.3 Purchasing power parity for GBP/DEM.
policy, ﬁscal policy, political developments, natural disasters andchanges in sentiment, as well as the balance of payments and inﬂation. The forecaster’s skill arises in selecting the appropriate factorsfrom time to time, as well as in forecasting those factors themselves.Short-term inﬂuences – market forcesAttitudes towards the foreign exchange market shift strongly fromtime to time, as different participants place different emphasis onparticular factors which inﬂuence market behaviour. In the earlyand mid-1970s, relative monetary growth became fashionable as acurrency indicator. In 1980, it was the turn of nominal and realinterest rates. During much of 1987/88, the focus was more on tradeimbalances. In 1988/89 attention turned more to interest rates again.In 1995, the biggest single emphasis was possibly on economic growthexpectations. From the introduction of the euro in 1999 onwards, theEUR/USD rate has been dominated by a rather intangible disenchantment with the strength and direction of European Central Bank(ECB) policy.No matter how irrelevant a factor may appear, potential changes inmarket focus makes that factor an essential element in exchange rateforecasting. The market is therefore often characterized by suddenshifts of sentiment which may violently distort supply and demandrelationships.Expectations also have a crucial role in exchange rate determination. A discrepancy between a previous expectation of a particulareconomic event and the actual outcome of that event may well
192
Foreign exchange and money markets
move an exchange rate. For example, a currency may strengthenin anticipation of a good economic announcement but then weakenperversely when the announcement is made, even if it is as good asexpected. Hence, there is a market saying: ‘‘Buy the rumour; sell thefact’’.It is not possible to suggest a recipe for forecasting. The essence offundamental forecasting is that it is judgemental and the forecaster’sjudgement may call for widely differing ingredients from time to time.The forward rateThe forward outright exchange rate is, in one sense, strictly themathematical result of combining the spot rate with interest rates,as we have seen in Chapter 2. In this sense, it cannot be a forecastof anything. Assuming free ﬁnancial markets, however, this is acircular argument. If the current forward rate differs from the averageexpectation of market participants, then those participants will tendto move the forward rate towards that expectation by buying or sellingthe currency. This will move the spot rate and/or the two interestrates involved. The result will be that the forward rate will tend toreﬂect this average market expectation; in this sense, it is a forecast.Effective exchange ratesAn effective exchange rate measures a currency’s average experienceagainst other currencies which are important to that country for tradepurposes. This average measure serves as a summary indicator ofthe currency’s performance and is therefore a useful basis for foreignexchange market intervention by the government.A real effective exchange rate measures the effective exchange rate,after adjustment for inﬂation differences between countries. This isuseful for judging the country’s competitive position in internationalmarkets.An effective exchange rate measures a currency’s average experience against other currencies.A real effective exchange rate adjusts this for inﬂation.
This Page Intentionally Left Blank
Part 4Risk Management
12
Bank riskmanagementOverviewIn this chapter, we focus mostly on the risks arising from the instruments discussed in this book. We do not, for example, consider therisks arising speciﬁcally from trading options.There are different ways of categorizing risks. The risks we describehere might therefore be grouped together slightly differently in anotherbook. This is unimportant to the understanding of the risks and theirmanagement. The list is also not exhaustive – the reader will no doubtcome across other examples.The ﬁrst two categories – market risk and credit risk – are riskswhich the bank often takes deliberately, in return for potential reward,in the normal course of its business – although it will be selective inthis, choosing to hedge against some of the risks from time to time.The remaining risks – operational risk, fraud, systemic risk, legal andregulatory risk and business risk – are risks which arise because ofthe mechanics of doing business, but which the bank seeks to avoid,or at least minimize.Many risks have a knock-on effect and affect more than 1 category.For example, failure to send a deal conﬁrmation (an operational risk)can lead to both market risk and credit risk. We have given examplesbelow of such knock-on effects.
Market riskThe risksMarket risk is the risk that the value of a position falls due to changesin market rates or prices. This is generally a major source of risk forthe bank.
196
Foreign exchange and money markets
As mentioned, this is a risk which the bank might take on deliberately, to the extent that it seeks to make a proﬁt by taking a positionin a particular market. However, there are also situations where amarket risk arises either unintentionally or unknowingly, possibly asa result of a credit or operational failure.Movements in any market can be relevant. In general, there are fourbroad categories of market prices which are usually considered – FX,interest rates, equities and commodities.Foreign exchangeA currency movement affects a spot dealer’s position in an obviousway. However, it also affects a forward swap dealer’s position; itis possible for a forward dealer to take a position which correctlyanticipates a market move in the forward swap rates, but whichcauses the bank a loss because of spot rate movements. This risk(the tail of the position) might not be correctly recognized by thedealer or correctly hedged. This is covered fully in Chapter 10.
Example 1A dealer buys USD 10 million against CHF. For each 1 point fallin the exchange rate, the bank would lose CHF 1,000.
Currency risks might in fact be less signiﬁcant than they appearwhen measured against the base or reporting currency, because ofcross-rate implications. For example, a yen-based organization mightreport two positions, the ﬁrst long EUR 10 million against yen and thesecond short DKK 75 million against yen. The net exposure of longeuros against kroner is likely to be a much less signiﬁcant one thanthe two JPY exposures viewed separately, because of the relationshipbetween the euro and the krone.Interest ratesThe value of many securities traded, including the ones discussedearlier in this book, is dependent on interest rates. If the bank holdsa short-term security to maturity, the cashﬂows are not vulnerableto interest rate movements because there are no interim cashﬂowsto be reinvested. However, the bank is still vulnerable because itcannot assume that the security will be held to maturity. Althoughthat might be the intention, changing circumstances might force anearly sale of the security at a time of high interest rates (and hencelow prices).
Bank risk management
197
A bank which buys or sells an FRA is also exposed to interest rates,as the settlement amount depends directly on the change in the ratebetween transaction and settlement.Example 2A dealer buys a 182-day US Treasury bill with face valueUSD 10 million, at a discount rate of 5.00%, for which he paysUSD 9,747,222.22. He funds the position at a day-to-day cost of5.20%.182= 9,747,222.2210,000,000 × 1 − 0.05 ×360The next day, if the discount rate is still the same, the billwould be worth USD 9.748,611.11, so that he has a mark-tomarket proﬁt of USD 1,388.89.181= 9,748,611.1110,000,000 × 1 − 0.05 ×360His funding cost so far is USD 1,407.939,747,222.22 × 0.052 ×
1= 1,407.93360
He is therefore running a loss of USD 19.04 per day.Other market risksThere are clearly markets other than currency and interest rateswhich can affect the bank’s position. Positions held in securitiesrelated to commodity markets or equities will clearly be affected bymovements in those markets. The risks might also be interrelated.For example, a rise in interest rates might weaken the equity market,so that a long position in interest rate securities might possibly bepartly relieved by a short position in equities. Currency movementssimilarly might affect some commodity prices, and commodity pricemovements might affect some equity prices.Market movements can also affect the value of collateral whichthe bank is holding against credit extended to its customers andcounterparties. This collateral is not part of the bank’s positions but,if the collateral value falls sharply, the bank becomes vulnerable to acredit risk which was previously secured.Basis riskBasis risk is the risk that two instruments do not move exactlyin line as anticipated. Suppose, for example, that the bank has
198
Foreign exchange and money markets
an FRA position which is matched by a futures position. The netposition should be invulnerable to interest rate movements. Thereis, however, a basis risk, as the two markets might in fact not moveexactly together. A similar basis risk might arise in any position,so that the actual price change is less favorable than the expectedchange.Example 3On 15 February 2002, the bank sells a 3v6 FRA to a customerfor USD 10 million at 4.90%. The bank hedges this by selling 10June futures contracts at 95.10. On 15 May, LIBOR is set at5.20% and therefore on 17 May the bank pays a FRA settlementof USD 7,566.12.92(0.052 − 0.049) ×360 = 7,566.1210,000,000 × 921 + 0.052 ×360Also on 15 May, the bank closes out the hedge by buying backthe 10 futures contracts. The price at that time is 94.85. Theproﬁt on the futures is USD 6,250.10,000,000 × (0.9510 − 0.9485) ×
3= 6,25012
The hedge has not matched the original exposure, because theJune futures price has not moved to the same extent as thedifference between the original FRA price and the LIBOR ﬁxingon 17 May.Liquidity riskLiquidity risk is related to market risk. It is the risk of being unableto ﬁnd a liquid market for a particular instrument, when the timecomes to close out a position. An extreme example of lack of liquidityoccurred following 11 September 2001 when the New York stockexchange was closed for several days, making it impossible to liquidate positions. A less extreme example is the common problem of aparticular stock or bond in which there is very little trading.Example 4A dealer sells an FRA to a customer in a minor currency,intending to hedge this using futures. He then ﬁnds that the
Bank risk management
199
futures market is not liquid enough to provide the hedge required, so that he must keep the risk uncovered for the moment.Model riskModel risk is the risk that a computer model used by a dealer to priceand value an instrument is wrong. This can also be considered asforming a part of operational risk rather than market risk.
Risk measurement and controlsMeasurementRisks are measured in various ways, some of which are appropriateto different instruments and in different situations.• Firstly, positions are netted for market risk. For example, if aUS dollar-based bank has only two deals, one of which is a spotpurchase of JPY 1 billion and the other of which is a spot sale ofJPY 1 billion, then there is zero market risk – although there islikely to be credit risk.• Banks continually mark-to-market trading positions. This meansthat the position is revalued by calculating the proﬁt or loss whichwould be realized if the position were closed out at current rates.This unrealized proﬁt or loss is taken into the accounts daily.• Risk on positions in interest rate instruments can be estimatedusing modiﬁed duration. This is a factor measuring the sensitivityof a position to changes in interest rates. For example, if a particular long position in a security has a modiﬁed duration of 4, thenan immediate increase of 0.01% in all interest rates would causean immediate loss of approximately 0.04% of the value of theposition.• Gap analysis – see below – is also used to measure risk on interestrate positions and forward FX positions.• Increasingly, banks use value at risk (VaR) to measure risk overall their positions. This is considered later in the chapter.LimitsAn essential control is to set maximum limits on the size of positionsand the extent of market risk which dealers are allowed to take, andto ensure that management procedures are in place to keep positionsstrictly within these limits. Limits are set in various ways:• Position limits are set for each trading position, depending on boththe instrument concerned and the experience and expertise of thedealer.
200
Foreign exchange and money markets
• Limits might be set on the maximum size of a single transaction.• Limits are set for the maximum size of a forward dealer’s or depositdealer’s gap exposure.• Limits are set for both intra-day positions (daylight limit) andpositions left open overnight (overnight limit).• Stop loss and take proﬁt levels are set. These are prices or rateswhich, if touched in the market, will trigger the closing of aposition, in order to avoid any further loss or to ensure that anexisting proﬁt is captured.• Limits are set for overall risk across various positions in differentsecurities or currencies.• Limits are set for overall risk across the bank’s worldwide operations, as well as in each center.• Limits are set on the level of VaR.Gap analysisGap analysis is a measure of the difference in exposures tointerest rates in different periods. Clearly a portfolio consisting ofa USD 1 million asset and a USD 1 million liability both of exactly1 year maturity, and a USD 2 million asset and a USD 2 millionliability both of exactly 2 years’ maturity is not at risk to interestrate changes in general, although it might of course involvebasis risk.If, however, the portfolio consists of the following net positions:1 year maturity:
short USD 3 million
10 years’ maturity:
long USD 3 million
then there is a risk to general changes along the yield curve, even ifthere is no basis risk.Suppose, for example, that interest rates rise by 0.5% for 1-yearyields and 0.8% for 10-year yields (a steepening positive yield curve,or a ﬂattening negative one). Broadly speaking, the effect will be again of USD 15,000 per annum for 1 year on the assets but a muchgreater loss of USD 24,000 per annum for 10 years on the liabilities.In order to control this risk, gap analysis considers a portfolio brokendown by period. In a major portfolio, this cannot conveniently be donein great detail, so that periods will be grouped, with more subdivisionof shorter time periods, where yield curve changes are likely to bemore pronounced. Thus, for example, maturities might be split asfollows:0–7 days 7–30 days 1–3 months 3–6 months 6–12 months 1–2 years 2–5 years 5–10 years
Bank risk management
201
Analysis in this way forces consideration of maturity imbalances,and of potential liquidity problems, but has several weaknesses, asfollows:• Because the groupings are discrete, the position can appear tochange sharply from one day to the next. For example, a loan of5 years plus one day would shift from one period to another a daylater, given the schedule suggested above.• For the same reason, if gap analysis shows a particular exposurewhich the bank wishes to cover, it is likely that the cover takenwill create a new risk later: the cover might reduce the gap now,but re-create another one in due course.• Most importantly, gap analysis does not take account of the timevalue of money on the assets and liabilities, or the reinvestmentrisks. A 5-year zero-coupon asset appears to match a 5-yearliability with semi-annual interest, whereas in fact the cashﬂowproﬁles are of course very different.Other controlsThere are other elements of control which should be in place,including the following:• All deals should be input immediately to the bank’s systems forboth settlement processing and risk measurement.• It is important that, for risk and accounting purposes, any transaction intended to be a hedge is linked to the underlying deal it isintended to cover.• There must be rigorous testing of computer valuation modelsbefore they are used.
Credit riskThe risksCredit risk is the risk that a counterparty might default on a transaction by failing to pay amounts due or failing to deliver a security orfailing in some other way (counterparty risk), or that the issuer of a