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How Do Canadian Banks That Deal in Foreign Exchange Hedge Their Exposure to Risk?

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  • Chris D'Souza

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File URL: http://www.bankofcanada.ca/wp-content/uploads/2010/02/wp02-34.pdf
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Bibliographic Info

Paper provided by Bank of Canada in its series Working Papers with number 02-34.

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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:
Handle: RePEc:bca:bocawp:02-34

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Keywords: Financial institutions; Market structure and pricing; Financial markets;

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  1. Chris D'Souza & Alexandra Lai, 2002. "The Effects of Bank Consolidation on Risk Capital Allocation and Market Liquidity," Working Papers 02-5, Bank of Canada.
  2. Kenneth A. Froot & Jeremy C. Stein, 1996. "Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach," NBER Working Papers 5403, National Bureau of Economic Research, Inc.
  3. H. Henry Cao & Richard K. Lyons & Martin D.D. Evans, 2003. "Inventory Information," NBER Working Papers 9893, National Bureau of Economic Research, Inc.
  4. Madhavan, Ananth & Smidt, Seymour, 1993. " An Analysis of Changes in Specialist Inventories and Quotations," Journal of Finance, American Finance Association, vol. 48(5), pages 1595-1628, December.
  5. Chow, Ying-Foon & McAleer, Michael & Sequeira, John M, 2000. " Pricing of Forward and Futures Contracts," Journal of Economic Surveys, Wiley Blackwell, vol. 14(2), pages 215-53, April.
  6. Hasbrouck, Joel, 1991. " Measuring the Information Content of Stock Trades," Journal of Finance, American Finance Association, vol. 46(1), pages 179-207, March.
  7. Stoughton, Neal & Zechner, Josef, 1999. "Optimal Capital Allocation Using RAROC And EVA," CEPR Discussion Papers 2344, C.E.P.R. Discussion Papers.
  8. Albéric Braas & Charles N. Bralver, 1990. "An Analysis Of Trading Profits: How Most Trading Rooms Really Make Money," Journal of Applied Corporate Finance, Morgan Stanley, vol. 2(4), pages 85-90.
  9. Cheung, Yin-Wong & Wong, Clement Yuk-Pang, 2000. "A survey of market practitioners' views on exchange rate dynamics," Journal of International Economics, Elsevier, vol. 51(2), pages 401-419, August.
  10. Cornell, Bradford & Reinganum, Marc R, 1981. "Forward and Futures Prices: Evidence from the Foreign Exchange Markets," Journal of Finance, American Finance Association, vol. 36(5), pages 1035-45, December.
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