Multi-Currency Options and Financial Institutions' Hedging: Correlation Does Matter

Article excerpt

SARAH K. BRYANT AND SPIROS H. MARTZOUKOS [*]

This paper examines one element of financial institutions doing business internationally: currency exchange risks. Such risks present significant barriers to profitably and competitively expand financial service markets. This paper compares the cost of alternative options hedging schemes in the presence of multi-currency uncertainties that affect the repayment of financial institutions' portfolios of loans (assets) and debt. Schemes that use separate contracts to hedge each uncertainty are compared to schemes with a single contract to capture all uncertainties simultaneously. The impact of correlation between the different currencies on such hedging policies is investigated. It is found that correlation matters and can significantly affect the cost and the contract choice. (JEL G20)

Introduction

Fluctuations in international currency markets cause financial institutions to face substantial currency risks. These risks arise most often when institutions make loans to customers denominated in foreign currencies, to raise funds denominated in foreign currencies, to purchase foreign-issued securities, or to deal in foreign currencies for the institution's own (or their customers') accounts. Evidence for U.S. and Japanese banks' substantial exchange rate exposure is provided, for example, in Chamberlain et al. [1997].

Institutions are faced with making portfolio adjustments by increasing foreign exposure. There are at least two reasons that adjustments take place. First, competition for loans and funding sources has grown, squeezing profit margins. In the U.S., institutions have experienced a decreasing market share for financial services as other financial service firms, domestic and foreign, have entered intermediary markets. Thus, some institutions have replaced a lost domestic market share and sources of income by competing with foreign institutions abroad. Second, in performing the role of financial intermediary, institutions have found ways to adjust their own portfolios to benefit the customer. Customers can borrow from institutions in the form of loans or they can lend money to institutions in the form of deposits in the customers' needed maturities, risk levels, currencies, and so forth. Financial intermediation inherently needs a customer orientation to be competitive. This also holds true for institutions that operate in foreign markets. An institution may want to be repaid interest and principal amounts in its own home currency and it may want to pay its debts in the same currency. In essence, borrowers and lenders to the institution would have to make portfolio adjustments by taking the exchange rate risk. However, competition may preclude that. Institutions that move into foreign markets where competition comes from in-country institutions must deal in in-country currencies.

Allowing borrowers the flexibility to repay loans in their own currency and to not accept currency exposure themselves can allow for greater loan market penetration. However, the institution is then responsible for hedging the resulting currency exposure. The institution can charge the customer for currency risk transfer by charging the cost of an option contract for the loan amount. However, to be competitive with in-country institutions, the institution must keep such charges to a minimum. Therefore, the lowest cost form of hedging becomes attractive.

Smith and Stulz [1985] show that a value-maximizing entity can hedge for three reasons: to reduce expected taxes, to reduce expected costs of financial distress, and because of managerial risk aversion. The cost of hedging can significantly reduce the effect of value maximization. This has empirical support from Nance et al. [1993]. Campbell and Kracaw [1990] argue that credible commitments to hedge reduce the agency cost of risky debt and benefits the firm's manager-equityholders. Schrand and Unal [1998] provide an explanation for hedging as allocating rather than reducing risk. …