sensitivity of foreign exhange trading income to exchange rate changes: A study of large U.S. banks, The
The recent growth in income from foreign exchange trading and the volatility of exchange rates have raised concern about the degree of sensitivity of banks’ trading profit to currency changes. Using two different models with semiannual data from 1980-94 the empirical (regression) results indicate that income from foreign exchange trading for eleven large U.S.A. banks are highly impacted by the level of exchange rate which is measured in terms of the trade weighted index of the U.S.A dollar and also the value of SDR. The implication of this riskiness is that the other sources of banks’ profit (consumer, commercial, and real estate loans) should not be neglected since policies to realign or unify currencies or to reduce their volatility could adversely affect trading income.
In recent years gains from foreign currency trading have been an important source of profits for the large U.S. commercial banks. More importantly, these gains have stabilized banks’ profitability after years of shrinking profits from corporate, consumer, and real estate loans. Recent data from the Annual Report of some banks indicate that from 1991 to 1992 Bankers Trust’ s foreign exchange trading income increased from $272 millions to $331 millions (21.69%), Chase Manhattan’s from $215 millions to $327 millions (52%), Chemical Bank’s from $289 millions to $476 millions (71.6%), Citicorp’s from $709 millions to $1,005 millions (41.7%), and together the nine “money center” banks from $1,811 millions to $2,695 millions (48.8%).
Three important factors have contributed to the rapid rise in foreign exchange trading. First, an increasing demand for foreign exchange services because of the rapid growth in international trade and international investments by multinational corporations and institutional investors. Second, a rapid growing global foreign exchange market with an estimated daily transaction of over $1 trillion and closely linked with the latest computer and communication technology. With regards to the U.S.A. foreign exchange market, the New York Times (Sept. 20, 1995), based on a recent survey, reported that in April 1995 the dail% turnover in the United States foreign exchange market was $244 billions, up 46 percent from $167 billions in April 1992. Also, according to this report, the U.S. market has almost doubled since 1989 and has risen more than tenfold since 1980. Finally, a volatile exchange rate environment which forces investors to change their positions quickly to avoid currency depreciation. The volatility creates enough uncertainty for traders to price currencies at a profitable spread.
Euromoney (September 1995) has also reported that the foreign exchange market has undergone significant structural changes over the past years. These changes include the following; (i) exchange rate fluctuations that are much larger and tend to persist longer than assumed, (ii) the inability of central banks to defend or stabilize their currencies through intervention, (iii) the declining role of fundamental factors in explaining the behavior of the market, (iv) the steady growth in the use of foreign currency derivatives, (v) the growing size of the market because of rapid globalization, and (vi) the increasing use of automated trading and real-time information which are believed to have at least contributed to the increase in the volatility of the market.
The extent to which currency fluctuation affects the foreign exchange trading income of banks is an empirical issue. A glance at the current literature indicates that no research on the sensitivity of exchange trading income to exchange rate changes has been done. This research focuses on this issue. Some of the recent studies focused on the impact of exchange rate risk on other financial variables such as stock returns, assets, valuation, and the overall economic exposure. These studies are briefly surveyed in another section of the paper.
The purpose of this paper is to empirically estimate the sensitivity of the foreign exchange trading income of eleven U.S. commercial banks to exchange rate changes. Nine of these banks are the large “money center” banks. We use regression analysis and semi-annual data for the period 1980 to 1994. The methodology is based on the approach by Adler and Dumas (1983) who suggested that a firm’s exchange rate risk exposure can be measured by the coefficient in a regression model in which the independent variable is exchange rate and the dependent variable any measure of profitability, eg. stock returns. Our model utilizes foreign trading income as the dependent variables. The period was one in which the U.S. dollar was rapidly weakening vis a vis the mark and the yen. In the latter part of 1995 the U.S. dollar as trading at a record low since World War 11 against these currencies but since then has been stabilized to a certain degree partly by coordinated central bank intervention. According to a report from the Federal Reserve Bank of New York (1995) the U.S. monetary authorities intervened in the foreign exchange markets on three occasions during the period – April 3, April 5, and May 31 purchasing a total of $3.6 bil. against German mark and the Japanese yen. Furthermore, the European exchange rate crises of November 1992 and August 1993 were important events during this period when the trading profits of US banks were significantly impacted by the currency turmoil. These were reported in the New York Times (Oct. 1992 and Aug. 1993).
This research is important because large banks are emphasizing the role of foreign exchange trading as a source of revenues or profits. The Wall Street Journal (July 30, 1993) reported that with traditional bank businesses shrinking, the big banks are increasingly reliant on foreign foreign exchange trading gains for revenue growth. They have developed competitive foreign exchange operations worldwide by increasing the number of foreign exchange dealing rooms, etc, and offering prices in many currency pairs. Additionally, as discussed by Johnson (1994) foreign exchange management has become an important part of large banks liquidity (asset, cash) management and some banks now treat foreign currency as a separate asset category. The very success of the foreign exchange operations of banks raise the ultimate question of whether the fate of the banking system is becoming increasingly dependent on currency speculation and volatility. This phenomenon has further created some fear among central bankers and government officers who have to spend resources to defend the value of their currencies under speculative attacks.
The results of this study could be beneficial information to bankers on the magnitude of the changes in exchange trading income due to changes in the exchange rate. This could impact decisions on asset management, especially those dealing with the stability of the other components on banks’ profitability such as consumer, commercial, and real estate loans. Furthermore, in the long run when central bankers find intervention to stabilize currency values ineffective then options as currency realignment, and currency unification could reduce currency volatility as well as profits from trading. Recently there has been much concern about the impact of the European Monetary Union (EMU) and the creation of a single currency (Euro) on overall international banking activities. The Banker (May 1997) reported that, based on a survey, the EMU would have a negative impact on foreign exchange profitability.
The structure of the papers is as follows: Section 11 discusses the nature of the exposure and risk inherent in foreign exchange trading. Section III presents a brief review of the literature on foreign exchange risk. Section IV develops the model. Section V presents and discusses the results, and Section VI focuses on the conclusion.
FOREIGN CURRENCY TRADING: EXPOSURE AND RISK
The foreign exchange market, with a daily turnover of $1.2 trillion, is the largest of all financial markets operating 24 hours per day in major centers as London, Tokyo, New York, Singapore, and Hong Kong. Saunders (1997: chapter 14) elaborated fours types of trading activities:
(i) The purchase and sale of foreign currencies to enable customers to partake in international trade transactions.
(ii) The purchase and sale of foreign currencies to allow customers (or the banks themselves) to take positions in foreign real (direct) and financial investments.
(iii) The purchase and sale of foreign currencies for hedging purposes to offset customers’ (or banks’) exposure in any given currency.
(iv) The purchase and sale of foreign currencies for speculative purposes through forecasting or anticipating future movements in foreign exchange rates.
In the first two activities, the banks act as agents for their customers and collect fees, thus they do not assume any foreign exchange risk. The fees are sometimes based on the bid/ask spread of the foreign currency; this spread is partly determined by the volatility of the currency, and also by the volume traded. In the third activity banks act defensively as a hedger to reduce foreign exchange exposure. The fourth activity relates to an unhedged open position in the foreign currency for speculative purposes and thus involves risk since profits depend on currency movements or the future value of the currency. Speculative trades could be implemented through a variety of foreign exchange instruments such as spot, foreign exchange forward contracts, futures, and options; however speculation in the spot market is most common. In past few years a variety of foreign currency financial derivatives have become available. Most profits or losses on foreign currency trading come from speculative activities. Fees from market making (bid/ask spread) or acting as agents for wholesale and retail customers provide only secondary sources of revenue. Based on the banks’ data, it must be emphasized that foreign exchange trading income is a highly volatile income source.
According to Saunders (1997) a bank’s overall exposure in a given currency could be measured by their net book or open position:
Net exposure = (foreign currency assets – foreign currency liabilities) + (Foreign currency purchased foreign currency sold), OR
Net exposure = net foreign currency assets + net foreign currency bought.
A positive net exposure position implies that a US bank is overall net long in a currency and faces the risk (loss in US$ value) that the foreign currency will depreciate (fall in value) against the US dollar. A negative net exposure position implies that a US bank is overall net short in a currency and faces the risk (higher US dollar cost) that the foreign currency could appreciate (rise in value) against the US dollar. The greater the bank’s net exposure in a foreign currency, and the greater that foreign currency exchange rate volatility, the greater is the potential dollar loss or gain to a bank. According to Saunders (1997:page 278);
Dollar loss/gain in currency, = (Net exposure in foreign currency measured in US dollars)* Shock (volatility) to the $/foreign currency, exchange rate.
Strategy-wise, a bank could match its foreign currency assets to its liabilities in a given currency and match buys and sells in its trading in that foreign currency to avoid foreign exchange risk, or it could offset an imbalance in its foreign asset/liability portfolio by an opposing imbalance in its trading so that its overall net exposure position in that currency could be zero. Failure to maintain a fully balanced position in any given currency exposes a bank to fluctuation in the foreign exchange rate of that currency against the dollar.
In recent years US largest commercial banks have been major participants in foreign exchange trading and dealing. The New York Times (Dec. 19, 1996) reported that in 1996 the market share of Citibank was 9. 1 %, Chase Manhattan 9.04%, J.P. Morgan 4.22%, and Bank of America 2.86%. These banks take significant positions in foreign currency assets and liabilities. Table I shows the outstanding US dollar value of US banks’ foreign assets and liabilities for the period 1992 to September 1996. The September 1996 figure for foreign assets was $68,129 million, with foreign liabilities of $ 111,112 million. Between 1992 and 1994 foreign currency assets have been decreasing while foreign liabilities have been increasing.
Table 2 gives a detailed breakdown of foreign currency positions of all US banks in five major currencies as of December 1993, the latest data available. US banks’ financial portfolio activities (the holding of assets and issuing of liabilities denominated in foreign currencies) are indicated by columns I and 2 respectively, while foreign currency trading activities (the spot and forward exchange contracts bought and sold are indicated by columns 3 and 4 respectively. The overall net position is indicated in column 5.
The data further show that foreign currency trading dominates portfolio investments for every category of foreign currency, also the German Mark is the most actively traded currency for both portfolio investments and foreign currency trading.
In recent years a new dimension to the foreign exchange market has been the rapid growth in the trading of foreign currency derivatives. The Banker (Sept. 1993) argued that this development was a response to banks providing additional hedging instruments for customers against exchange, inflation, and interest rate risks. Furthermore, Kodres (1996) contended that since these hedging strategies of many “exotic” and “plain vanilla” options require the continuous buying and selling of the underlying currencies, they increase the volume of currencies traded in the spot market.
LITERATURE REVIEW ON EXCHANGE RATE RISK
The advent of the floating (sometimes managed) exchange rate regime in the early 1970s and the rapid globalization of international business have stimulated much research on the impact of exchange rate movements on the profitability of MNCs and banks. Choi, Elyasiani. and Kopecky ( 1992) using data for the period 1975-1987 and regression analysis estimated the sensitivity of stock returns to market, exchange and interest rate risks for large USA banks. The results indicated the significance of exchange rate risk. Grammatikos, Saunders, and Swary (1986) using monthly data for the period December 1975 to November 1981 estimated the impact of exchange rate and interest rate risks on the returns of US banks’ foreign currency position within a portfolio setting. Foreign currency operations were judged for mean/variance efficiency and risk-adjusted performance. They concluded that US banks were not choosing optimal foreign currency portfolio. Choi and Prasad (1995) developed a model of firm valuation to examine the exchange risk sensitivity of 409 U.S. multinationals during the 1978-89 period. Dohner and Terrell (1992) utilized an empirical model to estimate the impact of exchange rate changes on the growth of total assets of some of the world’s largest banks over the period 1972-1989. Finally Bondar and Gentry (1993) made a comparative study of foreign exchange exposure of U.S.A, Japanese, and Canadian multinationals. The impact of exchange rate movements on the foreign exchange income of banks has yet to be investigated. Our research addresses this issue.
METHODOLOGY AND DATA
The banks in our study are Bankers Trust, Bank of New York, Chase Manhattan, Chemical, Citicorp, Republic, First Chicago, Bank of Boston, Mellon J.P. Morgan, and Bank America. A drop in TWI indicates a weakening of the $U.S. or strengthening of foreign currencies, as such if bi 0 (Eq. 2) it indicates that the strengthening (weakening) of the $U.S. vis a vis SDR decreases (increases) the dollar value of foreign exchange income. The data are from the following sources:
1. Income from foreign exchange trading: Bank Annual: Solomon Brothers, (various issues), Annual Report of Banks (various issues).
2. $/SDR: International Financial Statistic (IMF), various issues.
3. TWI/$: Survey of Current Business (U.S. Dept. of Commerce), various issues
Since the model is estimated in double logarithmic format then the coefficient measures the percentage change in the dependant variable (foreign exchange income) when the independent variable (TWI or $/SDR) changes by one percent. The results of Eq. 1. which utilizes the trade weighted index exchange rate (TWI/$) are presented on Table 3.
All the coefficients have the expected sign (a,>O) and are significant at the one percent level. This suggests that foreign exchange trading income is impacted by changes in the level of exchange rate as measured by SDR. The magnitude of this impact depends on the value of the coefficients; in descending order they are; Chemical (8.86), Bank of New York (8.68), Bankers Trust (6.26), Republic (6.13), Mellon (5.66), First Chicago (4.13), J. P. Morgan (3.09), Citicorp (2.99), Bank of Boston (2.87), Chase (2.99), and Bank America (2.4). Like the results of Eq. 1, there is further evidence of significant volatility in trading income due to changes in the level of exchange rate.
In comparing the results of Eq. I and Eq. 2, the interesting finding is that the order of the magnitude in which SDR and TWI affect trading income of the banks is similar, i.e. Chemical, Bank of New York, and Bankers Trust are most highly affected while Bank of Boston and Citicorp are the least. These results are also consistent with the ranking of the riskiness (fluctuation) of income from trading as measured by the coefficient of variation. The data on Table 5 show that Chemical, Bank of New York and Bankers Trust with the relatively highest coefficient of variation while Chase, Citicorp and Bank of Boston with the relatively lowest.
Our study investigates the important area of the impact of exchange rate movements on the foreign exchange trading income of large banks. The results indicate a significant relationship between bank trading income and the volatility in exchange rates. These results have important implications. First, it is imperative that the major US banks should not be too highly dependent on revenues or profits from foreign exchange trading. The other sources of banks’ profits, e.g. consumer, commercial, and real estate loans should also be properly managed. Second, in the long run if Central banks find it difficult to maintain or stabilize currency values through intervention, then policies to realign or unify currencies to reduce their volatility could adversely affect income and profits from foreign exchange trading. Third, the sensitivity of trading income to changes in the exchange rates should also be considered when banks take buying and selling positions in the foreign exchange market in order to minimize exchange rate exposure. Finally, with the possibility of the EMU in the year 2000 and the creation of a common currency (Euro) many banks’ trading income could be negatively affected.
Adler, M. and B. Dumas, 1983, “International Portfolio Choice and Corporation Finance: A synthesis,” Journal of Finance, vol. 38, 925-984.
Bank Annual: Solomon Brothers, New York, various issues.
“Banks Rely More on Trading, But Say Little About it”, Wall Street Journal, (July 30, 1993) Bondar, G. and W. Gentry, 1993, “Exchange Rate Exposure and Industry Characteristics: Evidence from Canada, Japan, and U.S.A.” Journal of International Money and Finance; Vol. 12,29-45.
“Changes in the Foreign Exchange Market”, Euromoney (Sept. 1995), pp. 2-14.
Choi J.J., E. Elyasiani and K. J. Kopecky, 1992,” The sensitivity of Bank Stock Returns to Market, Interest and Exchange Rate risks”, Journal of Banking and Finance, vol. 16, 9831004.
Choi, Jongmoojay and Anita Prasad, 1995, “Exchange Risk Sensitivity and its Determinants: A Firm and Industry Analysis of U.S. Multinationals. Financial Management, Vol. 24, 77-88.
Dohner, Robert and Henry Terrell, 1991, “Estimating the Impact of Exchange Rate Changes on the Asset Growth of Multinational Banks,” Journal of Financial Services Research, Vol. 5, 195-216.
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“Global Trade in Currency Shows Surge”, New York Times, Sept. 20, 1995.
Grammatikos, T., A. Saunders and 1. Swary, 1986, “Returns and Risks of US Bank Foreign Currency Activities”, Journal of Finance, vol. 41, 671-683.
International Finance Statistic I.M.F. Washington D.C., various issues.
Johnson, Hazel J., 1994, Bank Asset/Liability Johnson, __Hazel_ J.,
Management, (Probus Pub. Co., Chicago) Kodres, L. E., 1996, “Foreign Exchange Markets: Structure and Systemic Risks”, Finance & Development, (Dec.), pp. 22-25. Owen, J. 1997, “Single Currency: A fear in the Future”, The Banker, May, pp. 28-29.
“Profiting From Turmoil in Currencies” New York Times (Oct. 14, 1992)
Saunders, A., 1997, Financial Institution Management, (Richard D. Irwin, Chicago)
Survey of Current Business (U.S. Dept. of Commerce, Washington D.C.), various issues. “Swapping money: Volatility No more Calm Foreign Exchange Markets Mean Layoffs and Less Revenue” New York Times (Dec 19,1996) “The Stakes Go Up”, The Banker, (Sept. 1993) pp. 56-57
“Treasury and Federal Reserve Foreign Exchange Operations” Federal Reserve Bank of New York, (April June 1995).
Treasury Bulletin, (Department of Treasury, Washington D.C.) June, 1994.
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