How Do Canadian Banks That Deal in Foreign Exchange Hedge Their Exposure to Risk?
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Bibliographic InfoPaper provided by Bank of Canada in its series Working Papers with number 02-34.
Length: 40 pages Abstract: This paper examines the daily hedging and risk-management practices of financial intermediaries in the Canadian foreign exchange (FX) market. Results reported in this paper suggest that financial institutions behave similarly when managing their market risk exposure. In particular, dealing banks do not fully hedge their spot market risk. The results reported support arguments by Stulz (1996) and Froot and Stein (1998) that the amount of hedging will depend on a firm's comparative advantage in bearing risk. While the extent of hedging is found to depend on market volatility and the magnitude of their risk exposure, the uniqueness of the dataset employed in this paper allows for an explicit test of the various sources of comparative advantage that dealing banks in the FX markets have in their role as market-makers. Private information via customer order flow, guaranteed access to liquidity, and the capital-allocation structure of a dealer's financial institution are potential sources of comparative advantage to dealing banks in the FX market. A model with private information and an imperfectly competitive environment is provided to illustrate hedging when informed agents in a multiple security market behave strategically. Empirical results suggest that dealing banks only selectively hedge speculative positions taken in the spot market in the forward market. Findings also suggest that dealing banks share in the risk exposure of the spot market's net position without simultaneously hedging this risk.
Date of creation: 2002
Date of revision:
Contact details of provider:
Postal: 234 Wellington Street, Ottawa, Ontario, K1A 0G9, Canada
Phone: 613 782-8845
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Web page: http://www.bank-banque-canada.ca/
Financial institutions; Market structure and pricing; Financial markets;
Find related papers by JEL classification:
- F31 - International Economics - - International Finance - - - Foreign Exchange
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
This paper has been announced in the following NEP Reports:
- NEP-ALL-2002-11-28 (All new papers)
- NEP-CFN-2002-11-28 (Corporate Finance)
- NEP-IFN-2002-11-28 (International Finance)
- NEP-RMG-2002-11-28 (Risk Management)
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