Analysis of Foreign Exchange Market Risks - Literature review Example

ANALYSIS OF FOREIGN EXCHANGE MARKET RISKS According to Fama, E. (May 1970: 383-417) financial institutions are faced with a wide array of financial risks. Examples of financial risks include credit risk (Flood,R.P. and Garber,P.M., 1982), interest rate risk, liquidity risk, foreign exchange risk and political risk. This essay reports on credit risk, political risk and liquidity risk and how financial institutions that have interests in foreign exchange markets determine quality in order to minimize risks. It looks at implication of credit risk, political risk and liquidity risk. It looks into factors that control each risk and measures that are adopted to reduce magnitude of each risk. The objectives of risk assessment of a financial institution are first, to enable the financial institution to assess and aggregate credit data across disparate systems and sources. Second to enable the financial institution to integrate credit scoring and internal rating with credit portfolio risk assessment. Third, enables financial institution to accurately forecast measure, monitor and report potential risk exposures across the firm’s counterparty and portfolio level. Fourthly, to enable financial institution to evaluate substitute strategies for pricing, hedging and transferring credit risk. Fifth, to enable financial institution to ensure it satisfies regulatory compliance and risk disclosure requirements. Gloria,M.S. (2004: 1089-1110) suggested that credit risk is a measurable future default likelihood in terms of credit score or credit scorecard or credit analysis that reflects credit quality or credit worthiness subject to obligor’s or credit’s ability to satisfy its obligation. Gloria, M.S. added that financial institutions evaluate credit quality depending on type of credit risk in question or form of credit risk. Fama, E. (1970:383-417) and Gloria, M.S. (2004:1089-1110) reported existence of different types of credit risks namely individual credit risk, sovereign government credit risk, bank loans or derivative transactions. De Servigny (2004) proposed that financial institution assesses credit risk by evaluating three core factors. These factors that are used as measures of credit worthiness are default probability, credit exposure and recovery rate. Servigny (2004) defined default probability as a credit risk property that measures likelihood of a counterparty defaulting on its obligation either with respect to life of obligation or over a specified time frame for instance a year. Similarly Frenkel, A.B and Montgomery, J.D. (1991) outlined that in accordance to a specified time period of one year, default likelihood is expressed as expected default frequency. Servigny (2004), Frenkel, A. B. and Montgomery, J.D. (1991) and Servigny (2004) all agree that credit exposure is a credit risk parameter that evaluates and assesses quantitative aspect of the magnitude of outstanding obligation at the time when the default was presumed to take place. (Frenkel,A.B. and Montogery, J.D. (1991) argued that credit exposure is a forecast analytical tool that is a function of a default scenario taking place. Servigny (2004), Darell,D. and Singleton, K.J. (2003) and Servigny (2004) are of the idea that recovery rate is a credit risk assessment tool that that sets precedence in the event of a default. Bluhn, C. and Wagner,c. (2002) proposed that recovery rate parameter assesses the fraction of exposure that is likely to be recovered through bankruptcy proceedings or any other recommended form of default settlement. This shows that credit quality (Bluhn and Wagner, 2002) or worthiness should be a feasible measurable quantity of counterparty’s potential to perform on the obligation. BIS (1992) stated that credit quality is measured in terms of likelihood of obligation default and expected recovery rate. As a result, we can create a mathematical representation of credit risk in terms of credit exposure (BIS, 1993) and credit uncertainty by taking into account the dimension of the credit risk exposure and credit quality. Cranston, R. (1984) reported financial institutions determine credit quality in terms of credit score for individuals and small micro business enterprises and credit analysis for big institutions. Campbell Committee (May 1980; 1981) considered credit quality is evaluated before the financial institution makes a financial commitment to extend a loan. Collins, M.C. (1990) and Campbell Committee (May 1980; 1981) agreed that credit quality for an individual or a small micro business enterprise is measured by carrying out credit risk assessment. Corrigan, E.G. (1987), Davis, K. (1991), Davis, K. (1993) and Diamond, P.W. and Dybvig, P.H (1993) agreed that If the financial institution offers credit cards to its clients, the financial institution should evaluate the party’s annual income, evaluates possibility of an existing debt in terms of overdrafts or un-serviced institutional loan and also seeks to know if the party rents or owns income that can secure a loan as collateral. Corrigan, E.G. (1987) and Davis, K. (1991) observed that from the credit risk assessment, a number that meets criteria of information gathered is used as a credit score and determines if the individual or the small micro business enterprise is credit worth. Davis, K. (1991), Davis, K. (1993) and Diamond, P.W. and Dybvig, P.H (1993) reported that a financial institution can then deny or extend a credit to the individual or small micro business enterprise. On the other hand, (KMPG Peat Marwick, 1993) suggested that credit quality of a big institution is evaluated on the basis of credit analysis. KMPG Peat Marwick (1993) and Kane, E.J. (1981) determined that credit score is applied secondary to other assessment processes that are termed as human judgment tools. Accordingly Howard, J. (1978) reported that human judgment tools involve assessment of the institution’s balance sheet, income statements and the position of the institution based on ranking of the institutional financial performance. Davis, K. (1993) suggested human judgment tools that are analyzed include the current economic environment of the institution. Dybvig, P.H (1993) and Davis, K. (1993) agreed current economic environment helps to determine the nature of obligation and whether the institution is credit worth. Projections of the institutions future potential to default are examined. Debts have different credit qualities. Hogan, W.P. (1952) affirmed a big debt requires a higher credit quality as opposed to a small debt. Jensen, M.C. and Meckling, W.H. (October 1976) and Hogan, W.P. (1952) shown that after being equipped with this financial information, a credit analyst who is also known as an appraiser assigns a counterparty (that is also known as specific obligation) a credit rating. It is the credit rating that is used in making credit decisions. Greenvile, S. (1991) defined liquidity risk is a financial risk in response to uncertainty in liquidity. Meckling, W.H. (October 1976) and Hogan, W.P. (1952) agreed a financial institution is exposed to loss of its liquidity if its credit rating that is used as a measure of credit decision or credit score card falls. Greenvile, S. (1991), Meckling, W.H. (October 1976) and Hogan, W.P. (1952) illustrated that the effect of a decrease in credit scorecard to a financial institution is a phase of unexpected cash outflows or exposure of the financial institution to events that make counterparty to stop or withdraw counter trade or make the counter party to withdraw from lending to the institution. A financial institution or any lending institution is exposed to liquidity risk if the financial markets that the financial institution relies on have also suffered a decreased credit rating and are therefore victims of loss of liquidity. Hogan, W.P. (1952) in his definition suggested that liquidity is a universal set that tends to affect all other risks that financial institutions suffer or are exposed to. For example, if a financial institution is in a scenario that is characterized by illiquid state of its assets, the financial institution has a limited potential to liquidate its assets at a short notice because in so doing, the financial institution is likely to compound all its market risks. Further if we take the financial institution to have offsetting cash flows with two distinct counterparties on a specific day, if the counterparty that owes the financial institution a payment defaults, the financial institution has an option of raising money from the other source in order for it to make a payment. It the financial institution fails to attain any success, it too defaults. In this scenario, a liquidity risk takes a form of compounding credit risk. This implies that liquidity risk should be managed in addition to market risks, credit risk or interest risk (Gloria 2004). This is because liquidity risk has a tendency to compound other risks. This makes it difficult to isolate liquidity risk as an individual financial element. The only disadvantage is that there are no metric measurements for liquidity risks. Fama. E. (1970) suggested the only applicable competent model is asset liability management technique. The simplest techniques that can be used for liquidity involves looking at future cash flows on a daily basis. Kane,E.J. (1981) and Fama. E. (1970) have shown the process involves iterations with aim of evaluating if there is any specific day that gives a negative net cash flow that has a higher margin. This scenario is handled and solved by using stress testing technique (Litan, R.E. 1991) that involves evaluating the net cash flow on a day to day basis with a basic assumption that an important counterparty defaults. Such type of analyses involves competent utilization of contingent cash flows such as cash flows from derivative securities or mortgage backed securities. Litan, R.E. (1991) pointed out that if the financial institution is found to have large variants in its contingency, liquidity analysis are done by adopting scenario analysis. Scenario analysis involves creating a scenario for the market movement and defaults over a given specified time frame. Then assessment of day to day cash flows are made possible for each scenario build or constructed. There is however no standardization that can be used for reference since balance sheets for different financial institutions are different. With global concerns moving towards solutions to problems and challenges that affect financial institutions, there are growing concerns that are based on an increasing global climate of investment portfolio. It is important to evaluate a country’s risk levels to investors because this has an effect of affecting or predisposing political risks, financial risks, economic risks, composite risk indices as well as institutional investors country credit rating. These factors can have a positive or negative effect on the foreign exchange market. These factors have an effect or result of affecting any expected stock returns. There are a number of political factors that affect investment and expected stock returns. These include internal and external conflicts that may suppress activity of foreign exchange markets. Corrigan, E.G. (1987) has indicated that corruption; poor social and economic factors weaken local foreign exchange markets growth. The other factors that have political overtones in determining institutional risks include level of stability of government (Cranston, R. (1984) and predicted prevalence of peace. Other factors worth mentioning include ethnic tensions that can stimulate ethnic wars or civil wars, poor judicial systems that are characterized by non implemented law and order, lack of democratic space and democratic accountability and poor quality of bureaucracy. Investment profile is also an element of political factors that have significant contributions towards economic growth. Corrigan, E.G. (1987) and Collins, M.C. (1990) all indicated that political influence affects financial risks in terms of foreign debt that is expressed as a percentage of gross domestic product, foreign debt service of a country expressed in terms of exports of goods and services, current account as a function percentage of exports of good and services, stability of exchange rates and net international liquidity as a function of months over import cover. In addition Corrigan, E.G. (1987) economic risks is also another element of international risk guide for a country and is affected by key factors like per capita gross domestic product, real measurable gross domestic product growth and annual inflation rate, budget balance as a function of gross domestic product and current account as a function of gross domestic product. With respect to international risk guide for a country, a country’s risk measures are closely knit or correlated future equity returns. This is only applicable if and only if the country has characteristic emerging economies or markets. Grabosky, P. and Brathwaite, J. (1986) expressed this calls for segmentation of the emerging economy from a possible interference of world capital markets. Grabosky, P. and Brathwaite, J. (1986) and Greenvile, S. (1991) agree expected risk returns are evaluated or assessed by adoption of trading simulation technique, time series cross sectional analysis that links risk measures to future expected returns that affect book to price ratio and risk measures. According to Kane, E.J. (1981:355-367) risk management strategies that are commonly used utilize immunization portfolios like duration matching strategy, convexity strategy and M-square strategy. Kane, E.J. (1981:355-367) and Grabosky, P. and Brathwaite, J. (1986) expressed concern that there is deterioration in immunization performance on using traditional risk measures where there is prevailing high volatility in the foreign exchange markets. Such deterioration (Grabosky,P. and Brathwaite,J. ,1986) happens because traditional risk measures have a little competence hence are poor risk measures and secondly the duration matching strategy is not appropriate immunization instrument when there is prevalence of high volatility (Eugen, may 1970) because the yield curve shift is going to be very large. when active portfolio management criterion and duration matching and convexity matching strategy are used, immunization performance of traditional risk measures show a marked improvement at a high volatility segment of high yield. It should be noted that immunization performance of traditional duration and convexity measures deteriorate at low volatility segment of the yield core. Eugen May (1970:383-417) has shown under-performance of traditional risk measures subject to high volatility is due to poor risk measures but because duration matching strategy is not an appropriate immunization approach when there is high volatility in the market Jensen, M.C. and Meckling, W.H. (October 1976) and Goodhart, C.A.E. (1985) agree that under passive portfolio management criterion, performance of traditional models appears to be similar to duration matching strategy. Goodhart, C.A.E. (1985) found that generally29% of duration matched portfolios has returns that occur within one basis point of the target yield while passive portfolio management criterion is 100 percent basis points within target yield. Greenburn, S.I. and Higgins, B. (1985) shown that duration matching strategy is less likely to be sufficient enough to generate cash flows close to those of target bond yield. The duration matching strategy measure assumes a linear relation between the bond price and the yield change. If there are nonlinearities that are not taken into account by the duration measure then it means they are not significant. Cranston, R. (1984) and BIS (1992; 1993) agreed passive portfolio management criterion and bullet portfolio produces closer returns to the target yield for short holding periods when duration matching is employed. With duration and convexity matching strategy, bullet portfolio strategy, barbell portfolio strategy and minimum M- square portfolio strategy produce closer returns to the target yield for short holding periods. This shows that when duration matching strategy is used bullet portfolio is preferred to other portfolio formation strategies for short holding periods. When duration matching strategy and convexity matching strategy are used, there is no observed portfolio formation that emerges better than the other. In conclusion, financial lending institutions need to re-strategize on their criterion for risk management in order to balance risks and rewards. A high interest on a loan product is likely to lead into decrease in clients. Knox Lovell, C.A. and Schmidt S.S. (1993) felt that if interest rate is very low, the financial institutions is going to attract many clients and in the long run the financial institution will have reduced its profit margin or may even enter into losses or insolvency. If the financial institution has a lot of capital on reserve, the financial institution is likely to miss opportunities for investment revenue. Corrigan, E.G. (1987) reported financial institution may then expose itself to risk regulatory non-compliance and financial instability. 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