Wednesday, 15 January 2014

On-Balance Sheet Hedging and Off-Balance sheet Hedging Using Forwards






On-Balance Sheet Hedging and Off-Balance sheet Hedging Using Forwards

When is financial institution long and short in forex exposure?

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.