Interest rate risk and foreign exchange risk

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Interest rate risk and foreign currency exchange (forex) risk are two of the principal market risks that can hit an industrial firm, bank, insurance company, pension fund or asset management entity. All sorts of organizations have cash flow obligations to meet, and part of the investments they make as a 'war chest' are exposed to volatility of these two (and more) market risk factors:

• In the global marketplace, bonds are subject to interest rate risk and currency risk

• The value of stocks fluctuates as a result of equity price risk, and also of currency risk in the case of international investments, and

• Both debt instruments and equities are exposed to other risk factors like country risk, against which investors must always be able to reposition themselves.

A portfolio of investments, and most particularly a leveraged portfolio, can face trying times by being exposed to several market risks at once - particularly so as in the globalized economy there are many financial instruments: interest rates, currency exchange rates, equities and all sorts of derivatives are popular investment vehicles.

In principle, British investors can hedge against exchange rate risk by converting their future payment amount disbursed on their pound denominated investment into dollars in advance through covered interest parity. The principle underpinning this hedge states that the ratio between the forward and spot rates of the pound/dollar exchange rate must equal that between the interest factors of investments in the two currencies:

• Theoretically, returns on a domestic pound investment and a foreign dollar investment hedged by a forward transaction are equal

• In practice, market anomalies see to it that they are not; hence they are vulnerable to arbitrage exploiting interest rate differentials and/or forex differentials for profit.

Investors tend to favour covered interest rate parity. By contrast, speculators usually choose uncovered interest rate parity, connected to cross-border capital flows. Covered interest parity investments, however, have to be managed. This is done by comparing for each trading day the relationship between forward and spot pound/dollar exchange rates to the interest rate factors for three-month money market funds between America and Britain. (Mathematically, this can be tested by regressing the exchange rate ratio on the interest rate ratio.)

Uncovered interest rate parity implies that expected pound exchange rate depreciation vs. the dollar can be virtually matched by a correspondingly higher rate of interest from an investment in Britain compared to an investment in the USA.

• If a speculator does not hedge a transaction on the forward market

• Then resulting profit or loss hinges on future changes in spot exchange rate.

The model that addresses simultaneously interest rate and forex rate risk must be sophisticated. A British investor will earn more on a US investment than on a comparable investment in his or her country as long as a US interest rate advantage is not neutralized by a depreciation of the American dollar against the British pound. Under these circumstances:

• If one bases investment decisions on this strategy, he or she will weigh the portfolio more heavily in favour of US debt instruments

• On the other hand, if a majority of investors follows the approach to preferring US debt, this will result in significant capital export to the USA and will have other consequences.

Based on the late 18th century hypothesis by Thomas Reber Malthus with rats, cats and old maids, an appreciable trend towards dollar-denominated bonds will tend to have two consequences. One is falling interest rates in the USA, reflecting a rise in the price of debt instruments (which has been happening widely, with Chinese and Japanese buying US Treasuries and other dollar-denominated bonds). The other is an appreciation of the dollar, but:

• If the fundamentals remain unchanged

• Then this will lead to expectations that the US dollar will depreciate.

According to Malthusian theory, uncovered interest parity theory claims that in the medium term a state of equilibrium will be reached. In this, the expected returns on an unhedged investment in foreign currency should match those of a comparable investment in domestic currency. Will it?

In practical terms, in the early years of the 21st century the pound/dollar has not necessarily followed this hypothesis, as attested by the mid-August 2005 appreciation of the pound while British interest rates moved south and US interest rates went north. The Malthusian hypothesis is further shattered if one observes that the euro/dollar exchange rate tended to run counter to the interest rate differential.

This does not necessarily mean that Malthus got it wrong; it might have been right in his time, but after more than 200 years many things have changed. When this happens, theories sometimes turn on their head. In this particular case a significant risk premium has to be added to uncovered interest parity. On average, this means that a given interest rate advantage of a foreign investment should exceed the expected rate of appreciation of domestic currency by the amount of the risk premium required at transaction time.

This is, of course, a hypothesis that has to be tested. A fairly common test would be to assess the impact on currency rates of an upturn in long-term interest rates of the magnitude seen in 1994, when yields on US ten-year bonds increased from 5.8% to 8.1%, an impressive 230 basis points within a short period. For global banks another interesting test is that of a matrix of simultaneous interest rate and currency exchange changes in regard to their impact on their assets and liabilities.

With many instruments, mismatch risk should be a focal point. Also known as repricing risk, mismatch is the risk that banks' interest expenses will increase by more than interest receivables when interest rates change. Its origin lies in maturity mismatches between assets and liabilities. In foreign exchange, commercial banks face mismatch risk when they transfer money from one country to another for lending and investments, then they want to repatriate this money. That's why management often tries to raise money for loans locally.

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