On-Balance
Sheet Hedging and Off-Balance sheet Hedging Using Forwards
FI
is long when its assets are greater than liabilities and is short in exposure
if its liabilities are greater than assets.
The
mismatch between FI’s foreign financial asset and foreign financial liability
portfolio leads to FX exposure.
How to create
opportunities for higher returns in Forex market?
Banks
try to exploit forex market that creates opportunities using Off-balance sheet
and On-balance sheet hedging tools. This can be done either by increasing the
Return on asset (ROA) or by lowering cost of funds (COF) or both.
(1)
Let’s
see how Unhedged Balance Sheet is exposed to forex risk.
Let’s
say a U.S based FI has USD 200m 8% CDs for one year and loaned USD 100 million
in U.S at 9%, and USD100 million equivalent in U.K.loans at 15%. The exchange
rate is 1GBP = $1.60.
Extract
of Balance sheet
|
Assets
|
Liabilities
|
|
U.S.
loans (9%) = USD
100.0 m
|
USD
(8% CDs 1 year) = USD 200.0 m
|
|
U.K
loans (15% ) = GBP
62.5m (1GBP = USD1.60)
|
|
Rate
of interest in U.K.is 15% and in U.S. 9%
Let’s now compute Return
on Asset (ROA), Cost of Funds
(COF) and Return on Investments (ROI) under
two scenarios:
(1) When GBP depreciates
to 1GBP = $1.45
(2) When GBP appreciates
to 1GBP = $1.70
Computation
of ROA, COF and ROI
|
|
When GBP depreciates
|
When GBP appreciates
|
|
Exchange rate -
end of the year
|
1
GBP = 1.45 USD
|
1
GBP = 1.70 USD
|
|
Returns from U.K
Investment
62.5 x .15 =
71.875 GBP
Converting back
to USD we get
|
71.875
x 1.45
=
USD 104.22
Returns
in USD
=
4.22%
|
71.875
x 1.70
=
USD 122.18
Returns
in USD = 22.18%
|
|
ROA
|
.5
x 9% + .5 x 4.22% = 6.61%
|
.5
x 9%+.5 x 22.18% = 15.59%
|
|
COF
|
= 8%
|
= 8%
|
|
ROA – COF
= ROI
|
6.61% - 8%
= -1.39%
|
15.59% - 8%
= 7.59%
|
Inference: ROI is negative when GBP
is depreciating.
(2)
On-balance
sheet hedging - When GBP is depreciating and appreciating
Continuing
with our previous example, the FI has instead sold CDs equivalent to USD100
million each in U.S and U.K at 4% and 11% respectively. The extract of balance
sheet is given below.
Extract
of Balance sheet
|
Assets
|
Liabilities
|
|
USD
100 million U.S loans 9%
|
USD
100 million (U.S. 8% CDs 1 year)
|
|
USD 100 million
equivalent U.K. loans 15%
= 62.5 GBP
|
USD 100 million
in U.K CD’s (11%)
|
Exchange
rate at the beginning of the year 1GBP = $1.60
Let’s
now compute Return on Asset (ROA), Cost of Funds (COF) and Return on
Investments (ROI) under two scenarios using on-balance sheet hedging:
On-Balance
Sheet Hedging
|
|
When GBP depreciates
|
When GBP appreciates
|
|
Exchange rate -
the end of the year
Converting to GBP
100/1.60 = 62.5m
Interest rate = 15%
|
1 GBP = 1.45 USD
|
1 GBP = 1.70 USD
|
|
Returns from U.K.
investment
GBP 62.5 x 1.15 =
71.875
Converting it to
USD
|
71.875 x 1.45
= 104.22
Returns in USD = 4.22%
|
71.875 x 1.70
= 122.18
Returns in USD = 22.18%
|
|
Cost of funds
(U.S Loans)
|
8%
|
8%
|
|
Cost of funds
(U.K Loans)
62.5 x1.11
=69.375
|
69.375 x 1.45 =
110.59
Returns in USD =
.59%
|
69.375 x 1.70 =
117.938
Returns in USD =
17.938%
|
|
Weighted
average cost of funds
|
.5 x 8% + .5 x
.59%
=4.30%
|
.5
x 8% + .5 x 17.94% = 12.97%
|
|
Weighted
return on asset portfolio
|
.5
x 9% + .5 x4.22% = 6.61%
|
.5
x 9% + .5 x 22.18 % = 15.59%
|
|
|
|
|
|
Net
Return
|
6.61%
- 4.3% = 2.31%
|
15.59%
- 12.97% = 2.62%
|
Inference:
The firm can lock
in positive ROI even when GBP is depreciating.
When GBP appreciates
the firm can earn higher returns.
(3)
Balance
sheet hedging using Forwards
Continuing
with our previous example, suppose the bank enters into forward currency contract
at 1GBP = $1.55 the ROI would be:
|
Exchange rate -
end of the year
|
1
GBP = 1.55 USD
|
|
Returns from U.K
Investment
62.5 x .15 =
71.875 GBP
Converting back
to USD we get
|
71.875
x 1.55
=
USD 111.41
Returns
in USD = 11.41%
|
|
ROA
|
.5
x 9%+.5 x 11.41% = 10.21%
|
|
COF
|
= 8%
|
|
ROA – COF = ROI
|
10.21% - 8% = 2.21%
|
(4)
Comparison of Net Returns
|
Net
return (ROI)
|
When GBP depreciates
|
When GBP appreciates
|
|
Un-hedged
balance sheet
|
(1.39%)
|
7.59%
|
|
On-balance
sheet hedging
|
2.31%
|
2.62%
|
|
Off-balance
sheet hedging using forwards
|
|
2.21%
|
On-balance
sheet hedging is providing higher returns when GBP appreciates compared to Off-balance
sheet hedging using forwards.
