Balance sheet hedging

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i seem not to understand the concept underpinning off and on balance sheet hedging.what to calculate for , is it only about potential gains or losses on foreign exchange trades and how it impact on return on asset and return on investmented and the cost of fund?

in a nut shell can i say that; Foreign exchange risk is the risk that assets held in one currency loose value because the currency changes value?

thank you

Baffour

 

[David Harper CFA FRM]

Hi Baffour,

You pretty much have got it, at least with respect to the FRM assigned Saunders. The underlying idea is easier than the examples.

The baseline scenario is unhedged bank which is funded by domestically denominated liabilities (e.g., US dollars) and invests abroad (e.g. Eurozone).
Unhedged, as the ROI is the ROA - cost of funds (COF), the ROI depends on the return on assets (ROA).
So, to grossly round off, if the investment abroad returns + 15%, but the foreign currency depreciates (versus the dollar) by 10%, the currency-adjusted return is only ~5%. That is the basic FX exposure: the return on foreign investments, if unhedged, are reduced in net terms by relative currency depreciation (or equivalently, by domestic appreciation versus the foreign currency).

Then Saunders gives two hedges:
1. Match the funding (liabilities) with the asset exposure; in this way, currency depreciation will be hedged by a similar reduction in the COF. So, here the ROA is +/- stable because lower ROA is ~matched with lower COF (or, if appreciation, higher ROA is ~matched with higher COF). Balance sheet hedging --> matching funds (liabilities) to assets with respect to their currency exposure.
2. Simply using a foreign currency future/forward contract to give an outright hedge on the future conversion. Like other hedges (this is where new candidates sometimes get confused), this is a second, additional transaction: if foreign currency (e.g., EUR) depreciates against the dollar, the foreign investment still returns Euros but, in the additional transaction, those Euros have been sold forward for dollars at the predetermined forward FX rate. Off balance sheet --> using an additional FX forward/futures transaction as a hedge instrument.

I hope that helps, David