Directory UMM :Data Elmu:jurnal:I:International Review of Economics And Finance:Vol9.Issue3.July2000:

(1)

International Review of Economics and Finance 9 (2000) 267–286

Exchange rate exposure of the key financial

institutions in the foreign exchange market

Anna D. Martin*

School of Business, Fairfield University, Fairfield, CT 06430, USA Received 16 June 1998; accepted 7 September 1999

Abstract

Exchange rate exposure is assessed for key individual financial institutions, country-specific portfolios, and global portfolios. The results show that the majority of the key individual institutions are significantly exposed. U.K., Swiss, and Japanese portfolios are found to be significantly exposed, whereas U.S. portfolios are not exposed. There is also some evidence that exchange rate exposure does not exist on a global level. To the extent that the vast majority of currency trading is conducted among the financial institutions included in the portfolio, exposure is expected to be insignificant as gains accrued by one institution would

be offset by losses incurred by another institution. 2000 Elsevier Science Inc. All rights

reserved.

JEL classification:F31; G2

Keywords:Financial institutions; Exchange rate exposure; Interbank foreign exchange market

1. Introduction

Past studies on the exchange rate exposure of financial institutions have focused primarily on U.S. banks (e.g., Choi, Elyasiani, & Kopecky, 1992; Wetmore & Brick, 1994; Chamberlain, Howe, & Popper, 1997; Choi & Elyasiani, 1997). Even though U.S. banks dominate the foreign exchange (FX) interbank market, non-U.S. banks are also heavily involved in the FX market. A 1996 survey byEuromoney identifies 30 financial institutions from around the world that constitute 75% of the FX market.

* Corresponding author. Tel.: 203-254-4000, ext. 2881; fax: 203-254-4105. E-mail address: [email protected] (A.D. Martin)

(2)

Table 1

Top 30 financial institutions based on 1996 foreign exchange market share

1996

National Westminster Bank United Kingdom 4.90

J.P. Morgan United States 4.22

Union Bank of Switzerland (UBS) Switzerland 3.53

Barclay’s Bank United Kingdom 2.98

Royal Bank of Canada Canada 1.66

National Australia Bank Australia 1.58

Tokyo-Mitsubishi Bank Japan 1.44

Banque Nationale de Paris (BNP) France 1.37

Bank of Montreal Canada 1.20

Royal Bank of Scotland United Kingdom 0.74

Bank of Scotland United Kingdom 0.72

The figures in this table are taken from the currency trading survey published inEuromoney(1996).

Table 1 displays their estimated 1996 market shares and countries of origin. This list reveals that eight U.S. institutions control 30% of the FX market and twenty-two non-U.S. institutions control 45% of the FX market. Institutions from the U.K., Switzerland, Hong-Kong, France, Germany, Canada, and Japan control 12, 8, 6.5, 4, 3.5, 3, and 2%, respectively. Interestingly, the largest banks in the world do not necessarily dominate the FX market. Using a 1996 ranking by Institutional Investor, 4 of the 10 largest banks in the world are not considered to be key FX participants.

(3)

over the 1975–1987 time period. Wetmore and Brick (1994) find some U.S. bank portfolios are significantly exposed to exchange rate risk over the 1986–1991 time period. Chamberlain, Howe, and Popper (1997) report that approximately 30% of U.S. banks and 10% of Japanese banks are significantly exposed over the 1986–1993 time period. Choi and Elyasiani (1997) find 80% of the largest U.S. banks are signifi-cantly exposed over the 1975–1992 time period.

The present research contributes to the literature in the following ways. First, exchange rate exposure is assessed for the key financial institutions that comprise the interbank FX market. Differences in exchange rate exposure across the institutions in this study may be attributed to differing degrees of risk aversion and levels of proficiency in managing the exposure. The market should recognize significant expo-sure for those institutions that are less risk averse and/or less proficient in managing their foreign exchange exposure.1

Second, differences in exposure across countries are analyzed. Eleven different countries are represented by the institutions in the sample. Differences in exposure across countries may be attributed to differing regulatory and supervisory requirements (e.g., Chamberlain, Howe, and Popper, 1997). Even though the Basle Accord of 1988 initiated uniform minimum capital standards for internationally active banks, it provides only guidelines. In reality, it is unlikely that consistent practices are followed (Barth, Nolle, & Rice, 1997).

Lastly, this study assesses whether exchange rate exposure exists at a global level. A portfolio comprised of the key financial institutions involved in the FX market may be viewed as a system in which all FX trading is conducted. Gains by one institution would be offset by losses of another. A simplified example may help clarify this point. Assume there are two institutions (Trader A and Trader B) whose only business is trading foreign exchange with each other. The variance of a portfolio that contains these two companies would be:s2

p5 s2AWA2 1 s2BW2B12sAsBrAB. Since a trade would

consist of one trader winning and the other trader losing, rAB 5 21. Furthermore,

there exists a portfolio with proportions WA and WB that minimizes the variance,

where the portfolio variance is zero. Therefore, it can be argued that there is no foreign exchange exposure from a global portfolio perspective.

2. Data and estimation

Exchange rate exposure is assessed for the key FX institutions and for various portfolios. More specifically, a multi-factor model similar to Madura and Zarruk (1995) and Choi and Elyasiani (1997) is used. The model is estimated using the seemingly unrelated regression (SUR) methodology of Zellner (1962):

Rit 5 b0i1 b1iRmt 1 b2iIjt 1 b3iXjt1 mit

(i51 . . . I;j51 . . . J;t5 1 . . .T) (1)

(4)

Rit5return on individual institution or portfolioiat weekt;

Rmt5return on the Dow Jones World Stock Index at weekt;

Ijt5return on the interest rate index for country jat weekt;

Xjt5return on the exchange rate for countryj at weekt;

b0i5intercept for individual institution or portfolioi;

b1i5coefficient measuring the exposure of individual institution or portfolioi

to world market risk;

to interest rate risk;

to exchange rate risk; and

mit5residual for theith equation at week t.

Eq. (1) is estimated using weekly data over the 1994-1996 time period (i.e. T 5

156).2_{The competitive nature of the FX market makes it difficult to generalize about}

the extent of involvement of these particular financial institutions in the FX market prior to 1994. The Federal Reserve Bank of New York (1996, p. 120) substantiates this claim:

The market structure statistics suggest that the foreign exchange market is highly competitive. Among the top ten dealers, only four dealers’ ranking remained unchanged between 1992 and 1995. Among the dealers who were in the top ten in either 1992 or 1995, four dealers saw their ranking fall by five or more places, while four dealers saw their ranking rise by five places or more.

Although most previous studies use monthly data to estimate exchange rate expo-sure, Wetmore and Brick (1994) employ weekly data. Because this study examines a three-year period, weekly observations are considered more appropriate than monthly observations.

Stock prices are gathered from the Wall Street Journal (WSJ). Deutsche Morgan Grenfell, Goldman Sachs, Indosuez, and Bank of Scotland are excluded either because they are not listed on a major exchange or their stock prices are not provided in the WSJ. Thus, 26 of the top 30 FX participants are analyzed [i.e.,I526 in Eq. (1)]. All interest rates and exchange rates are taken from theEconomist.Past studies involving global financial institutions also have used these data sources (e.g., Madura & Zarruk, 1995). With the exchange rate measured in foreign currency units per domestic cur-rency units, positive exchange rate exposure coefficients indicate unhedged short (long) foreign currency (domestic currency) positions.

The interest rate returns are calculated as the rate of change in the nominal long-term interest rates of the countries in the sample. There are 11 countries represented by the financial institutions in the sample [J 5 11 in Eq. (1)]: Australia, Canada, France, Germany, Holland, Hong Kong, Japan, Sweden, Switzerland, the United Kingdom, and the United States.3 _{The use of long-term interest rates is consistent}

(5)

used since studies such as Choi, Elyasiani, and Kopecky (1992) and Madura and Zarruk (1995) find the exposure to actual and unanticipated interest rate changes to be quite similar.

Because of evidence that suggests actual exchange rate changes may obscure expo-sure (e.g., Choi, Elyasiani, and Kopecky, 1992), unanticipated exchange rate changes are also used in this study. More specifically, the mean unanticipated return in the value of the domestic currency, measured in terms of the foreign currencies represented by the institutions in the sample, is used. The unanticipated return on the currency of countryj,Xjt, is defined in Eq. (2) as:

Xjt 5A(Xjt) 2E(Xjt) (2)

where

A(Xjt)5actual rate of change in the value of the domestic currency of countryj

relative to the foreign currency at week t; and

E(Xjt)5expected rate of change in the value of the domestic currency of

coun-tryjrelative to the foreign currency at weekt, where the expected rate of change is based on the international Fisher effect (IFE).

The actual and expected rates of change are calculated relative to each of the 10 foreign currencies separately. The mean of these unanticipated exchange rate changes as well as the mean of actual exchange rate changes are ultimately used to represent the exchange rate factor in Eq. (1).4

The expected return is estimated according to IFE. Thus, E(Xjt) is projected for

each country j based on nominal interest rate differentials5 _{between country} _j _and

each of the remaining 10 foreign countries:

E (Xjt) 5

(11 Ijt)

(11Ift)

(3)

where

Ijt5interest rate for domestic countryjat weekt; and

Ift5interest rate for foreign country f at weekt.

3. Results

Tables 2–11 present the regression coefficients that have been estimated by Eq. (1) for the key FX institutions and various portfolios. White’s (1980) test does not detect heteroskedasticity to be pervasive.6 _{However, autocorrelation is frequently}

detected. Therefore, when the Durbin-Watson (D-W) test indicates autocorrelation may be present, a one-period lagged return,Ri,t21, is included in Eq. (1). This adjustment

corrects autocorrelation in every case.

(6)

Table 2

Individual exchange rate exposure estimates using unanticipated changes in the value of the domestic currency

Institution b0 b1 b1(lag) b2 b3 D-W

Citibank 0.009 1.29 20.32 20.16 0.41 2.10

(2.63)*** (4.12)*** (25.30)*** (20.75) (1.06)

Chase Manhattan 0.007 1.33 — 0.04 0.29 2.19

(2.27)** (5.15)*** (0.20) (0.93)

HSBC/Midland 0.001 1.18 — 20.16 20.00 1.93

(0.58) (5.88)*** (21.70)* (20.01)

Natl Westminster 0.001 1.08 20.23 20.15 20.17 1.96

(0.45) (5.26)*** (24.51)*** (21.50) (20.79)

JP Morgan 0.004 0.67 20.20 20.37 0.18 2.14

(1.35) (2.90)*** (23.37)*** (22.30)** (0.65)

UBS 20.002 0.70 — 0.04 20.29 2.16

(21.03) (3.51)*** (0.48) (21.58)

Barclay’s 0.004 0.99 20.28 0.04 20.18 1.93

(1.65)* (5.04)*** (25.28)*** (0.38) (20.86)

BankAmerica 0.006 1.11 0.02 20.27 0.46 2.23

(2.52)*** (5.22)*** (0.41) (21.91)* (1.83)*

SBC 0.006 0.58 — 20.02 20.67 2.07

(2.22)** (3.07)*** (20.46) (24.22)***

ABN AMRO 0.003 1.01 — 20.00 20.38 1.78

(1.62) (6.41)*** (20.14) (22.03)**

Credit Suisse 0.002 0.71 — 20.00 20.29 2.07

(0.75) (3.30)*** (20.10) (21.57)

Std Chartered 0.005 1.03 20.21 20.18 20.37 1.91

(1.38) (3.24)*** (23.54)*** (21.24) (21.12)

SE Banken 0.012 1.37 — 20.01 1.69 2.06

(3.28)*** (4.94)*** (20.06) (6.33)***

RB Canada 0.005 0.81 20.18 20.06 0.55 2.14

(2.23)** (4.41)*** (23.29)*** (21.00) (3.23)***

Natl Australia 0.004 0.52 20.13 20.27 0.32 2.09

(1.59) (3.12)*** (21.88)* (23.96)*** (1.70)*

Tokyo-Mitsubishi 20.012 0.81 20.40 20.00 0.88 2.03

(20.57) (0.91) (25.68)*** (20.07) (0.88)

BNP 20.001 0.69 20.17 20.12 0.54 2.00

(20.41) (2.66)*** (23.09)*** (21.16) (1.18)

B of Montreal 0.004 0.91 20.19 0.01 0.39 1.93

(1.68)* (4.94)*** (23.50)*** (0.20) (2.28)**

Lloyd’s 0.006 0.82 20.28 0.05 0.02 1.97

(2.00)** (3.55)*** (24.67)*** (0.43) (0.10)

Bankers Trust 20.000 1.03 — 0.01 20.00 2.11

(20.13) (4.29)*** (0.08) (20.01)

Merrill Lynch 0.004 1.91 — 20.30 0.64 2.15

(1.56) (7.50)*** (21.74)* (2.12)**

First Chicago 0.001 1.11 — 20.06 0.14 2.04

(7)

Table 2 (Continued)

Societe Generale 20.003 0.63 — 20.10 20.25 2.03

(21.06) (3.02)*** (21.30) (20.71)

Fuji 20.019 1.42 — 20.02 0.77 2.10

(22.92)*** (5.63)*** (20.99) (2.66)***

Commerzbank 20.001 0.46 — 20.28 0.52 1.89

(20.40) (3.26)*** (24.20)*** (2.56)***

RB Scotland 20.000 0.20 — 20.22 20.42 2.17

(20.03) (0.86) (21.99)** (21.69)*

Rit5 b0i1 b1iRmt1 b2iIjt1 b3iXjt1 mitis estimated with weekly data over the 1994–1996 period using SUR methodology.Ritis the equity return for institutioni.Rmt is the return on the Dow Jones World Stock Index.Ijtis the return on the nominal long-term interest rate for the associated country.Xjtis the mean unanticipated change in the value of the associated domestic currency, where the anticipated component is projected using IFE. A one-period lagged return,Ri,t21, is included when it is necessary to correct autocorrelation. The coefficients are reported witht-values in parentheses.

* significant at the 0.10 level; ** significant at the 0.05 level; *** significant at the 0.01 level. D-W is Durbin-Watson.

(actual) return on foreign currency per domestic currency, as previously described. Table 4 (Table 5) reports the coefficients when the exchange rate factor is measured as the unanticipated (actual) return on an equally weighted composite of the foreign currencies represented by the sample per U.S. dollar.

The results in Table 2 and Table 3 show that 11 of the 26 (42%) institutions are significantly exposed to exchange rate movements. Positive exposure is revealed for 8 institutions, indicating they have a net long position (net of hedging) in their domestic currencies, while negative exposure is revealed for 3 institutions. In general, institutions that reveal significant exposure may be less risk averse and are attempting to achieve higher rates of return. The institutions that are not significantly exposed may be risk averse and employ proficient FX personnel and internal control systems.7

The specific institutions that are found to be significantly exposed does differ slightly between Table 2 and 3. In Table 2, only 2 of the 7 (29%) U.S. institutions are exposed, while 9 of the 19 (47%) non-U.S. institutions are exposed. In Table 3, only 1 of the 7 (14%) U.S. institutions is exposed, while 10 of the 19 (53%) non-U.S. institutions are exposed. Across both Tables 2 and 3, the exposure coefficients in absolute value terms range from 0.20 to 1.91 for the contemporaneous market risk, 0.00 to 0.37 for interest rate risk, and 0.00 to 1.69 for exchange rate risk. The size of the coefficients helps assess the relative importance of these exposures for individual institutions. For the majority of the cases, the absolute size of the contemporaneous market exposure coefficients (b1) is greatest, and the absolute size of the exchange rate exposure

coefficients (b3) is greater than the interest rate exposure coefficients (b2).

(8)

Table 3

Individual exchange rate exposure estimates using actual changes in the value of the domestic currency

Citibank 0.008 1.27 20.32 20.17 0.37 2.10

(2.45)*** (4.09)*** (25.29)*** (20.78) (0.93)

Chase Manhattan 0.006 1.31 — 0.03 0.19 2.19

(2.09)** (5.10)*** (0.15) (0.58)

HSBC/Midland 0.001 1.17 — 20.16 0.04 1.94

(0.63) (5.83)*** (21.73)* (0.20)

(0.87) (5.32)*** (24.55)*** (21.50) (21.12)

JP Morgan 0.003 0.67 20.20 20.37 0.16 2.14

(1.22) (2.88)*** (23.37)*** (22.30)** (0.56)

UBS 20.001 0.71 — 0.04 20.34 2.16

(20.45) (3.57)*** (0.50) (21.88)*

Barclay’s 0.005 1.01 20.28 0.04 20.26 1.93

(2.22)** (5.12)*** (25.32)*** (0.44) (21.24)

BankAmerica 0.005 1.10 0.02 20.28 0.36 2.24

(2.07)** (5.15)*** (0.38) (21.95)** (1.40)

Std Chartered 0.007 1.03 20.21 20.19 20.34 1.90

(2.00)** (3.23)*** (23.52)*** (21.28) (21.05)

SE Banken 20.002 1.35 — 20.01 1.63 2.04

(20.51) (4.89)*** (20.11) (6.09)***

RB Canada 0.003 0.79 20.17 20.05 0.54 2.15

(1.43) (4.31)*** (23.11)*** (20.97) (3.13)***

Natl Australia 0.001 0.53 20.13 20.26 0.45 2.11

(0.71) (3.21)*** (21.92)* (23.72)*** (2.27)**

(0.52) (0.97) (25.68)*** (20.02) (1.08)

BNP 20.002 0.70 20.18 20.10 1.12 2.00

(20.83) (2.74)*** (23.21)*** (21.01) (2.29)**

B of Montreal 0.002 0.90 20.19 0.01 0.39 1.94

(1.12) (4.87)*** (23.39)*** (0.21) (2.22)**

Lloyd’s 0.006 0.81 20.28 0.05 0.08 1.97

(2.10)** (3.50)*** (24.69)*** (0.42) (0.33)

Bankers Trust 20.000 1.04 — 0.03 0.14 2.13

(20.12) (4.35)*** (0.15) (0.47)

Merrill Lynch 0.003 1.90 — 20.29 0.70 2.17

(0.97) (7.52)*** (21.70)* (2.23)**

First Chicago 0.001 1.09 — 20.08 0.02 2.05

(0.14) (2.94)*** (20.30) (0.04)

(9)

Table 3 (Continued)

(20.85) (3.13)*** (21.12) (0.45)

Fuji 20.003 1.46 — 20.02 1.13 2.12

(21.03) (5.80)*** (20.81) (2.64)***

Commerzbank 0.000 0.47 — 20.28 0.53 1.90

(0.13) (3.33)*** (24.22)*** (2.42)***

RB Scotland 0.002 0.20 — 20.23 20.39 2.16

(0.75) (0.86) (22.01)** (21.58)

Rit5 b0i1 b1iRmt1 b2iIjt1 b3iXjt1 mitis estimated with weekly data over the 1994–1996 period using SUR methodology.Ritis the equity return for institutioni. Rmt is the return on the Dow Jones World Stock Index.Ijtis the return on the nominal long-term interest rate for the associated country.Xjtis the actual change in the value of the associated domestic currency. A one-period lagged return,Ri,t21, is included when it is necessary to correct autocorrelation. The coefficients are reported witht-values in parentheses.

the U.S. dollar. This result is consistent with previous studies that have also shown U.S. banks on average maintain net long U.S. dollar positions (e.g., Choi, Elyasiani, & Kopecky, 1992; Chamberlain, Howe, & Popper, 1997). Although, Choi and Elyasiani (1997) find a substantial number of the largest U.S. banks have net short U.S. dollar positions.

Across both Tables 4 and 5, only 1 of the 7 (14%) U.S. institutions is exposed, while 13 of the 19 (68%) non-U.S. institutions in Table 4 and 16 of the 19 (84%) non-U.S. institutions in Table 5 are exposed. In absolute value terms, the exposure coefficients range from 0.12 to 1.91 for the contemporaneous market risk, 0.00 to 0.38 for interest rate risk, and 0.08 to 1.28 for exchange rate risk. Again, the majority of the cases show the size of the contemporaneous market exposure coefficients (b1) is

greatest, and the absolute size of the exchange rate exposure coefficients (b3) is greater

than the interest rate exposure coefficients (b2).

Choi and Elyasiani (1997) also find a great proportion of U.S. banks to be signifi-cantly exposed. There are some differences in results that may arise because of differ-ences in the sample and/or sample period. Choi and Elyasiani (1997) study U.S. banks, whereas this study focuses on the key global financial institutions that are heavily involved in the FX market. As Choi and Elyasiani (1997) indicate, U.S. banks use derivatives for hedging purposes. The U.S. financial institutions in the current study may not reveal significant exposure if they effectively utilized derivatives to manage their risk during the examination period.

(10)

Table 4

Individual exchange rate exposure estimates using unanticipated changes in the value of the U.S. dollar

Citibank 0.009 1.30 20.31 20.15 0.39 2.12

(2.58)*** (4.17)*** (25.14)*** (20.69) (0.98)

Chase Manhattan 0.006 1.33 — 0.04 0.27 2.19

(2.22)** (5.16)*** (0.23) (0.82)

HSBC/Midland 0.004 1.22 — 20.15 0.74 1.83

(1.62) (6.30)*** (21.65)* (2.76)***

(1.89)* (5.73)*** (22.80)*** (21.04) (3.10)***

JP Morgan 0.003 0.66 20.20 20.38 0.12 2.14

(1.27) (2.85)*** (23.30)*** (22.34)** (0.41)

UBS 0.000 0.67 — 0.02 0.39 2.16

(0.06) (3.35)** (0.21) (1.40)

Barclay’s 0.007 1.02 20.28 0.06 0.82 1.97

(3.12)*** (5.38)*** (24.47)*** (0.65) (3.14)***

BankAmerica 0.006 1.10 0.02 20.27 0.30 2.23

(2.29)** (5.16)*** (0.36) (21.95)** (1.10)

SBC 0.004 0.64 — 20.01 1.13 2.03

(1.73)* (3.42)*** (20.24) (4.38)***

ABN AMRO 0.003 1.04 0.16 20.01 0.51 1.97

(1.56) (6.57)*** (2.46)** (20.78) (2.31)**

Credit Suisse 0.002 0.74 — 0.00 0.68 1.98

(0.79) (3.49)*** (0.01) (2.30)**

Std Chartered 0.009 1.07 — 20.18 1.16 2.22

(2.45)** (3.43)*** (21.25) (2.72)***

SE Banken 0.001 1.38 — 20.06 0.52 2.02

(0.37) (4.62)*** (20.46) (1.25)

RB Canada 0.003 0.84 20.07 20.04 0.25 2.29

(1.39) (4.49)*** (21.54) (20.69) (0.97)

Natl Australia 0.002 0.53 20.12 20.26 0.35 2.10

(1.21) (3.17)*** (21.88)* (23.78)*** (1.65)*

(0.80) (0.99) (25.69)*** (0.18) (1.04)

BNP 0.001 0.72 20.17 20.13 1.04 2.00

(0.24) (2.82)*** (23.15)*** (21.24) (2.90)***

B of Montreal 0.003 0.97 — 0.04 0.35 2.21

(1.18) (5.16)*** (0.63) (1.32)

Lloyd’s 0.008 0.87 20.24 0.06 0.67 2.00

(2.73)*** (3.87)*** (24.27)*** (0.59) (2.21)**

Bankers Trust 20.001 1.02 — 0.00 20.08 2.10

(20.22) (4.24)*** (0.02) (20.24)

Merrill Lynch 0.005 1.91 — 20.29 0.71 2.14

(1.62) (7.52)*** (21.71)* (2.18)**

First Chicago 0.002 1.15 — 20.00 0.36 2.03

(0.40) (3.10)*** (20.01) (0.75)

(11)

Table 4 (Continued)

(20.13) (3.23)*** (21.22) (1.84)*

Fuji 20.000 1.49 — 20.01 0.99 2.18

(20.11) (6.03)*** (20.51) (2.88)***

Commerzbank 0.002 0.48 — 20.28 0.48 1.86

(0.96) (3.39)*** (24.11)*** (2.51)***

RB Scotland 0.000 0.12 — 20.22 20.44 2.14

(0.14) (0.50) (22.01)** (21.35)

Rit5 b0i1 b1iRmt1 b2iIjt1 b3iXt1 mitis estimated with weekly data over the 1994–1996 period using SUR methodology.Ritis the equity return for institutioni. Rmtis the return on the Dow Jones World Stock Index.Ijtis the return on the nominal long-term interest rate for the associated country.Xjtis the mean unanticipated change in the value of the U.S. dollar, where the anticipated component is projected using IFE. A one-period lagged return,Ri,t21, is included when it is necessary to correct autocorrelation. The coefficients are reported witht-values in parentheses.

portfolios are constructed for those countries that have at least three institutions in the top 30 list of FX participants (see Table 1). The remaining institutions are placed in an equally weighted All Others portfolio. The estimates in Panel A of Table 6 (Table 7) use the unanticipated (actual) return on the equally weighted composite of foreign currencies per domestic currency, except the estimates for the All Others portfolio use the unanticipated (actual) return on the equally weighted composite of foreign currencies per U.S. dollar. The estimates in Panel B of Table 6 (Table 7) use the unanticipated (actual) return on the equally weighted composite of foreign currencies per U.S. dollar. The results in Panel A of Tables 6 and 7 do not indicate that the country-specific portfolios are exposed to currency movements. Only the exposure of the Switzerland portfolio is marginally significant in Panel A of Table 7. In Panel B of Tables 6 and 7, the U.K. and Switzerland portfolios are shown to be significantly exposed to movements in the value of the U.S. dollar. In both panels of both tables, the All Others portfolio is significantly exposed.

Table 8 (Table 9) presents the exposure estimates of country-specific portfolios to the unanticipated (actual) change in three bilateral exchange rates: DM/$ in Panel A, ¥/$ in Panel B, and £/$ in Panel C. The composition of these country-specific portfolios differ from those used in Tables 6 and 7 in that only the top 10 key traders of the corresponding currency pair are included. Equally weighted country-specific portfolios are constructed for countries with at least three institutions in the top 10 list of key traders identified by Euromoney. Note that Sumitomo and Industrial Bank of Japan are considered to be key ¥/$ traders but are not in the top 30 list of FX participants.

(12)

Table 5

Individual exchange rate exposure estimates using actual changes in the value of the U.S. dollar

Citibank 0.008 1.28 20.31 20.16 0.46 2.12

(2.44)*** (4.13)*** (25.19)*** (20.74) (1.14)

Chase Manhattan 0.006 1.32 — 0.04 0.28 2.19

(2.09)** (5.14)*** (0.21) (0.83)

HSBC/Midland 0.002 1.21 — 20.14 0.96 1.86

(0.81) (6.38)*** (21.56) (3.59)***

(0.95) (5.44)*** (24.57)*** (21.39) (2.63)***

JP Morgan 0.003 0.67 20.20 20.37 0.22 2.15

(1.23) (2.88)*** (23.32)*** (22.29)** (0.73)

UBS 20.001 0.66 — 0.02 0.39 2.16

(20.44) (3.30)** (0.19) (1.36)

Barclay’s 0.005 1.00 20.27 0.06 0.84 1.88

(2.34)** (5.29)*** (25.17)*** (0.66) (3.15)***

BankAmerica 0.005 1.10 0.02 20.27 0.36 2.23

(2.08)** (5.16)*** (0.36) (21.92)* (1.27)

SBC 0.001 0.61 — 20.01 1.27 2.07

(0.33) (3.36)*** (20.18) (4.91)***

ABN AMRO 0.002 1.01 — 20.01 0.72 1.80

(1.27) (6.47)*** (20.68) (3.23)***

Credit Suisse 0.000 0.73 — 20.00 0.83 2.00

(0.06) (3.46)*** (20.01) (2.77)***

Std Chartered 0.008 1.01 20.22 20.17 1.22 1.89

(2.15)** (3.31)*** (23.71)*** (21.18) (2.83)***

SE Banken 20.000 1.37 — 20.06 0.81 2.06

(20.02) (4.65)*** (20.51) (1.90)*

RB Canada 0.003 0.84 20.16 20.05 0.46 2.14

(1.33) (4.53)*** (22.85)*** (20.91) (1.75)*

Natl Australia 0.001 0.53 20.13 20.26 0.44 2.11

(0.74) (3.18)*** (21.91)* (23.66)*** (2.03)**

(0.47) (0.95) (25.76)*** (20.01) (0.61)

BNP 20.002 0.70 20.17 20.12 1.08 2.01

(20.77) (2.74)*** (23.14)*** (21.17) (2.95)***

B of Montreal 0.002 0.94 20.17 0.01 0.54 1.93

(1.10) (5.10)*** (23.19) (0.21) (2.05)**

Lloyd’s 0.006 0.85 20.30 0.07 0.85 1.94

(2.32)** (3.81)*** (25.16)*** (0.66) (2.71)***

Bankers Trust 20.000 1.04 — 0.03 0.12 2.12

(20.13) (4.35)*** (0.16) (0.38)

Merrill Lynch 0.003 1.91 — 20.28 0.87 2.16

(0.99) (7.57)*** (21.65)* (2.61)***

First Chicago 0.001 1.13 — 20.03 0.32 2.04

(0.16) (3.04)*** (20.12) (0.66)

(13)

Table 5 (Continued)

(20.78) (3.19)*** (21.16) (1.99)**

Fuji 20.003 1.49 — 20.01 0.88 2.15

(21.14) (5.89)*** (20.69) (2.49)***

Commerzbank 0.000 0.47 — 20.28 0.56 1.87

(0.15) (3.34)*** (24.18)*** (2.87)***

RB Scotland 0.002 0.13 — 20.22 20.38 2.14

(0.64)- (0.56) (21.99)** (21.15)

Rit5 b0i1 b1iRmt1 b2iIjt1 b3iXt1 mitis estimated with weekly data over the 1994–1996 period using SUR methodology.Ritis the equity return for institutioni. Rmtis the return on the Dow Jones World Stock Index.Ijtis the return on the nominal long-term interest rate for the associated country.Xtis the actual change in the value of the U.S. dollar. A one-period lagged return,Ri,t21, is included when it is necessary to correct autocorrelation. The coefficients are reported witht-values in parentheses.

only the All Others portfolios are shown to be significantly exposed to the German mark and Japanese yen.

For the country-specific portfolios, the magnitude of the exposure coefficients is clearly greatest for market risk in Tables 6 through 9. However, it is not as clear whether exchange rate exposure or interest rate exposure is relatively more important. These results also hold for the global portfolios that are analyzed in Tables 10 and 11 and are yet to be discussed.

The U.S. portfolio in Tables 6 through 9 is consistently found to be insignificantly exposed, whereas the non-U.S. country-specific portfolios are often found to be signifi-cantly exposed. These findings may be attributed to differing regulatory and supervi-sory requirements (e.g., Chamberlain, Howe, & Popper, 1997). Under the auspices of ensuring the safety and soundness of the U.S. banking system, the U.S. government may be more restrictive when compared to most other countries (Barth, Nolle, & Rice, 1997).8_{Considering the threat of financial systems crises across the world and}

previous experiences with the U.S. financial system crisis, it is also possible that U.S. FX institutions as a whole are more reluctant to accept exchange rate risk than their global competitors.

The exposure of various global portfolios to the unanticipated (actual) change in a multilateral exchange rate and three different bilateral rates are reported in Table 10 (Table 11).9_{The estimates for the Market Share portfolios, which are market}

(14)

Table 6

Exposure of country portfolios to unanticipated changes in multilateral exchange rates

b0 b1 b1(lag) b2 b3 D-W

Switzerland 0.002 0.62 — 20.05 20.25 2.14

(0.75) (3.88)*** (21.32) (21.57)

All Others 0.002 0.81 20.16 20.17 0.53 2.04

(1.97)** (8.31)*** (22.82)*** (22.44)** (4.21)***

Switzerland 0.002 0.66 — 20.04 0.74 2.05

(1.09) (4.20)*** (21.23) (3.37)***

All Others 0.003 0.81 20.17 20.17 0.63 2.01

(2.23)** (8.37)*** (22.93)*** (22.46)** (4.72)***

Rit5 b0i1 b1iRmt1 b2iIjt1 b3iXjt1 mitis estimated with weekly data over the 1994–1996 period using SUR methodology.Rit is the equity return for portfolioi. Rmtis the return on the Dow Jones World Stock Index.Ijtis the return on the nominal long-term interest rate for the associated country, except the All Others portfolio uses an equally weighted interest rate index. In Panel A, Xjt is the mean unanticipated change in the value of the associated domestic currency, except the All Others portfolio uses the value of the U.S. dollar. In Panel B,Xjtis the unanticipated change in the value of the U.S. dollar. The anticipated returns are projected using IFE. A one-period lagged return,Ri,t21, is included when it is necessary to correct autocorrelation. The coefficients are reported witht-values in parentheses. * significant at the 0.10 level; ** significant at the 0.05 level; *** significant at the 0.01 level. D-W is Durbin-Watson.

used to assess the exposure to the three bilateral rates are constructed using the key traders of the associated currency pair as reported by Euromoney. Numerical scores are provided instead of market share estimates for the key traders of these currency pairs. Thus, these portfolios are pseudo-market share-weighted. The estimates for the Global Index, which is a global composite consisting of approximately 50 major money center banks from 17 countries are provided in Panel B in Tables 10 and 11. This market capitalization-weighted index is constructed by Dow Jones.

(15)

Table 7

Exposure of country portfolios to actual changes in multilateral exchange rates

b0 b1 b1(lag) b2 b3 D-W Panel A

Portfolio

U.S. 0.004 1.16 20.13 20.23 0.31 1.99

(2.07)** (6.70)*** (21.98)** (21.85)* (1.40)

U.K. 0.004 0.80 20.15 20.15 20.11 2.00

(2.08)** (4.78)*** (21.95)** (21.73)* (20.55)

Switzerland 0.000 0.61 — 20.05 20.28 2.15

(20.13) (3.83)*** (21.30) (21.78)*

All Others 0.001 0.80 20.17 20.16 0.64 2.07

(0.73) (8.46)*** (23.05)*** (22.31)** (5.01)*** Panel B

Portfolio

U.S. 0.004 1.16 20.13 20.23 0.34 2.00

(2.07)** (6.72)*** (21.95)** (21.82)** (1.50)

U.K. 0.003 0.84 — 20.13 0.68 2.22

(1.88)* (5.18)*** (21.46) (3.02)***

Switzerland 0.000 0.65 — 20.04 0.83 2.07

(20.01) (4.15)*** (21.16) (3.75)***

All Others 0.001 0.80 20.18 20.16 0.73 2.05

(0.76) (8.50)*** (23.16)*** (22.32)** (5.49)***

Rit5 b0i1 b1iRmt1 b2iIjt1 b3iXjt1 mitis estimated with weekly data over the 1994–1996 period using SUR methodology.Rit is the equity return for portfolioi. Rmtis the return on the Dow Jones World Stock Index.Iitis the return on the nominal long-term interest rate for the associated country, except the All Others portfolio uses an equally weighted interest rate index. In Panel A,Xjtis the actual change in the value of the associated domestic currency, except the All Others portfolio uses the value of the U.S. dollar. In Panel B,Xjt is the actual change in the value of the U.S. dollar. A one-period lagged return,Ri,t21, is included when it is necessary to correct autocorrelation. The coefficients are reported witht-values in parentheses.

the 50 major global money center banks that constitute this index represent a greater proportion of the FX market, there is some evidence that exchange rate exposure does not exist on a global basis.

4. Conclusion

(16)

Table 8

Exposure of country portfolios to unanticipated changes in three bilateral exchange rates

Japan 0.015 1.27 20.29 0.01 0.80 2.00

(2.95)*** (4.85)*** (24.29)*** (0.46) (4.11)***

All Others 0.001 1.06 20.09 20.32 0.31 2.07

(0.66) (7.34)*** (21.53) (23.01)*** (2.19)**

Rit5 b0i1 b1iRmt1 b2iIjt1 b3iXjt1 mitis estimated with weekly data over the 1994–1996 period using SUR methodology.Rit is the equity return for portfolioi. Rmtis the return on the Dow Jones World Stock Index.Iitis the return on the nominal long-term interest rate for the associated country, except the All Others portfolio uses an equally weighted interest rate index.Xjtis the unanticipated change in the specified bilateral rates. The anticipated component is projected using IFE. A one-period lagged return,Ri,t21, is included when it is necessary to correct autocorrelation. The coefficients are reported witht-values in parentheses.

a_X

tis the change in DM/US$. b_X

tis the change in ¥/US$. c_X

tis the change in £/US$.

Exposure estimates for country-specific portfolios reveal that U.S. portfolios are consistently found to be insignificant, whereas U.K., Swiss, and Japanese portfolios are found to be significantly exposed. These results may be attributed to more restrictive regulatory and supervisory requirements placed on U.S. financial institutions (e.g., Barth, Nolle, and Rice, 1997). It is also plausible that U.S. institutions are relatively more risk averse, given the threat of global/regional financial systems crises, and especially in light of past experiences with crises in the U.S. financial system.

(17)

Table 9

Exposure of country portfolios to actual changes in three bilateral exchange rates

All Others 0.002 0.98 20.08 20.33 0.08 2.10

(0.95) (6.70)*** (21.32) (23.14)*** (0.47)

Rit5 b0i1 b1iRmt1 b2iIjt1 b3iXjt1 mitis estimated with weekly data over the 1994–1996 period using SUR methodology.Rit is the equity return for portfolioi. Rmtis the return on the Dow Jones World Stock Index.Iitis the return on the nominal long-term interest rate for the associated country, except the All Others portfolio uses an equally weighted interest rate index.Xjtis the unanticipated change in the specified bilateral rates. The anticipated component is projected using IFE. A one-period lagged return,Ri,t21, is included when it is necessary to correct autocorrelation. The coefficients are reported witht-values in parentheses.

a_X

tis the change in DM/US$. b_X

tis the change in ¥/US$. c_X

tis the change in £/US$.

a substantial amount of trading is conducted outside the system. However, the exposure of a more comprehensive global index to multilateral or bilateral exchange rates is not found to be statistically significant. This finding lends some support to the premise that exchange rate exposure does not exist from a global portfolio perspective.

Acknowledgments

(18)

Table 10

Exposure of global portfolios to unanticipated changes in exchange rates

b0 b1 b1(lag) b2 b3 Adj. R2 D-W Panel Aa

Exchange Rate Factor,Xt

FC index/US$ 0.003 1.04 — 20.27 0.39 0.5043 2.14

(2.59)*** (10.72)*** (23.46)*** (2.95)*** OLS.Rtis the return on the global portfolio.Rmtis the return on the Dow Jones World Stock Index.It is the return on the equally weighted global interest rate index constructed using nominal long-term rates.Xtis the unanticipated change in the value of the U.S. dollar, specified below. The anticipated component is projected using IFE. A one-period lagged return,Rt21, is included when it is necessary to correct autocorrelation. The coefficients are reported witht-values in parentheses.

* Significant at the 0.10 level; *** significant at the 0.01 level. a_R

tis the return on the Market Share portfolio. b_R

tis the return on the Global Index.

Notes

1. It is recognized that financial institutions trade foreign exchange on behalf of their client business and their own account. Given the desire and proficiency to manage their exposure, the source of exposure is not relevant.

2. Stock price data for Banque Nationale de Paris (BNP) are not available until March 14, 1994. As a result, T 5 146 when BNP is included in the system or portfolio.

(19)

Table 11

Exposure of global portfolios to actual changes in exchange rates

b0 b1 b1(lag) b2 b3 Adj.R2 D-W Panel Aa

Exchange Rate Factor,Xt

FC index/US$ 0.003 1.05 20.11 20.26 0.57 0.5453 2.04

(2.46)*** (11.18)*** (22.07)** (23.44)*** (4.24)*** OLS.Rtis the return on the global portfolio.Rmtis the return on the Dow Jones World Stock Index.It is the return on an equally weighted global interest rate index constructed using nominal long-term rates. Xtis the actual change in the value of the U.S. dollar, specified below. A one-period lagged return,Rt21, is included when it is necessary to correct autocorrelation. The coefficients are reported witht-values in parentheses.

** significant at the 0.05 level; *** significant at the 0.01 level a_R

tis the return on the Market Share portfolio. b_R

tis the return on the Global Index.

4. I would like to thank an anonymous reviewer for recommending that the analysis be conducted and reported when actual exchange rate changes are used to verify that the results of this study are not an artifact of the way the exchange rates are specified.

5. The results are not materially different whether short-term or long-term interest rates are used to derive the expected component of the exchange rate factor. Thus, the estimates generated when using the short-term interest rates are reported for those models using the unanticipated exchange rate change as the exchange rate factor. The 3-month Eurocurrency data and corporate bond yield data provided in the Economist are used to represent nominal short-term and long-term interest rates, respectively.

(20)

hetero-skedasticity. When analyzing the various portfolios, only the All Others portfolio in one situation reveals significant heteroskedasticity.

7. Unfortunately, institution-specific data for non-U.S. institutions are scarce which hinders the identification of factors that may influence exposure to differ across the institutions in the sample. However, various cross-sectional analyses have been attempted to ascertain significant determinants using 1996 data provided byInstitutional Investorand 1996 market share figures provided byEuromoney. The data compiled by Institutional Investor focus on the world’s 100 largest banks and are available for 17 of the 26 institutions in the sample. The factors analyzed are: FX market share, core capital, tier-1 ratio, total capital ratio, total assets, non-performing loans/total assets, reserves/non-performing loans, and liquid assets/total assets. None of these factors are found to be significant determi-nants of exchange rate exposure.

8. Even though Grammatikos, Saunders, and Swary (1986) do not find evidence that the probability of ruin due to foreign currency positions is significant for U.S. banks, they acknowledge that contagion effects from announcements of foreign exchange losses may impair the functioning of the banking system. 9. These results may be considered mainly relevant to the dollar market since the

exchange rates are anchored to the U.S. dollar.

References

Barth, J.R., Nolle, D.E., & Rice, T.N. (1997). Commercial banking structure, regulation, and performance: an international comparison. Washington, DC: Office of the Comptroller of the Currency, Economics Working Paper 97-6, March.

Chamberlain, S., Howe, J.S., & Popper, H. (1997). The exchange rate exposure of U.S. and Japanese banking institutions.Journal of Banking and Finance 21, 871–892.

Choi, J.J., & Elyasiani, E. (1997). Derivative exposure and the interest rate and exchange rate risks of U.S. banks.Journal of Financial Services Research 12, 267–286.

Choi, J.J., Elyasiani, E., & Kopecky, K.J. (1992). The sensitivity of bank stock returns to market, interest, and exchange rate risks.Journal of Banking and Finance 16, 983–1004.

Euromoney. (1996). A close chase. (May), 63–70.

Federal Reserve Bank of New York. (1996).The foreign exchange committee: Annual report 1995. Grammatikos, T., Saunders, A., & Swary, I. (1986). Returns and risks of U.S. bank foreign currency

activities.Journal of Finance 41, 671–682.

Institutional Investor. (1996). The world’s 100 largest banks. (August), 75–85.

Kane, E.J., & Unal, H. (1988). Change in market assessments of deposit institution riskiness.Journal of Financial Services Research 1, 207–229.

Madura, J., & Zarruk, E. (1995). Bank exposure to interest rate risk: A global perspective.Journal of Financial Research 18, 1–13.

Wetmore, J.L., & Brick, J.R. (1994). Commercial bank risk: market, interest rate, and foreign exchange. Journal of Financial Research 17, 585–596.

White, H. (1980). A heteroskedasticity-consistent covariance matrix and a direct test for heteroskedasticity Econometrica 48, 817–838.