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The Currency Composition of Firms' Balance Sheets and its Effect on Asset Value Correlations and Capital Requirements

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Abstract

We extend the Tasche (2007) model on the asset correlation bias caused by a currency mismatch between assets and liabilities to the more realistic situation where some assets, and some, but not necessarily all, liabilities, are denominated in a foreign currency. To test the significance of the remaining bias we rely on a unique data base constructed by The Inter-American Development Bank (IADB) containing time-series of the asset- and liability currency composition of firms in a group of Latin American countries. Net currency mismatches are calculated and are found to vary from country to country. The correlation bias itself also varies significantly from country to country and has often been economically significant during the last 20 year-period. We find that the bias regularly is of the same magnitude as the correlation itself even in countries where the average firm has a fairly low degree of currency mismatch. Looking at market-wide corporate credit portfolios in four Latin American countries, we show that the credit risk, and associated Basel II capital charges, could increase by as much as a fifth, on average across our sample, if the actual currency mismatch in firms’ balance sheets is acknowledged. In some cases the currency mismatch-induced capital charge could increase much more, sometimes to levels several times (hundreds of percent) the original capital requirement.

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  • Byström, Hans, 2016. "The Currency Composition of Firms' Balance Sheets and its Effect on Asset Value Correlations and Capital Requirements," Working Papers 2016:1, Lund University, Department of Economics.
  • Handle: RePEc:hhs:lunewp:2016_001
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    1. Martín Tobal, 2013. "Currency Mismatch: New Database and Indicators for Latin America and the Caribbean," Documentos de Investigación - Research Papers 12, Centro de Estudios Monetarios Latinoamericanos, CEMLA.
    2. Byström, Hans, 2014. "The impact of currency movements on asset value correlations," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 31(C), pages 178-186.
    3. Hoyt Bleakley & Kevin Cowan, 2008. "Corporate Dollar Debt and Depreciations: Much Ado About Nothing?," The Review of Economics and Statistics, MIT Press, vol. 90(4), pages 612-626, November.
    4. Klaus Duellmann & Jonathan Küll & Michael Kunisch, 2010. "Estimating asset correlations from stock prices or default rates - which method is superior?," Post-Print hal-00736734, HAL.
    5. Andre O Santos & Jorge A Chan-Lau, 2006. "Currency Mismatches and Corporate Default Risk; Modeling, Measurement, and Surveillance Applications," IMF Working Papers 06/269, International Monetary Fund.
    6. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    7. Lee, Shih-Cheng & Lin, Chien-Ting & Yang, Chih-Kai, 2011. "The asymmetric behavior and procyclical impact of asset correlations," Journal of Banking & Finance, Elsevier, vol. 35(10), pages 2559-2568, October.
    8. Dirk Tasche, 2007. "Incorporating exchange rate risk into PDs and asset correlations," Papers 0712.3363, arXiv.org.
    9. Takashi Hashimoto, 2009. "Asset correlation for credit risk analysis -- Empirical study of default data for Japanese companies --," Bank of Japan Working Paper Series 09-E-3, Bank of Japan.
    10. Duellmann, Klaus & Küll, Jonathan & Kunisch, Michael, 2010. "Estimating asset correlations from stock prices or default rates--Which method is superior?," Journal of Economic Dynamics and Control, Elsevier, vol. 34(11), pages 2341-2357, November.
    11. Crouhy, Michel & Galai, Dan & Mark, Robert, 2000. "A comparative analysis of current credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 59-117, January.
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    More about this item

    Keywords

    asset correlation; bias; exchange rate; currency composition; currency mismatch;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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