Hey all! I came across this currency swap question during my derivatives review and am a little confused with the solution - although the explanation was very intuitive, I don’t understand how my logic, which yielded a wrong answer, doesn’t hold true. Here was my reasoning: I looked at the situation as the US Bank has assets (ie. loans) denominated in US dollars and liabilities denominated Hong Kong dollars. Then, since the bank is using the CDs to fund its US Dollar loans I reasoned that the bank had the risk of the Hong Kong dollar depreciating against the US dollar, thus making the US dollar more expensive and decreasing the amount of loans the bank can make (ie. decrease asset value). Like I said before, the explanation below does make sense, but I was really hoping someone could tell me why my thought process is wrong. Thanks Here is the Question: Consider a U.S. commercial bank that takes in one-year certificates of deposit (CDs) in its Hong Kong branch, denominated in Hong Kong dollars, to fund three-year, fixed-rate loans the bank is making in the U.S. denominated in U.S. dollars. Why would this bank wish to enter into a currency swap? The bank faces the risk that the Hong Kong dollar: A) decreases in value against the U.S. dollar and the risk that interest rates increase in Hong Kong. B) decreases in value against the U.S. dollar and the risk that interest rates decrease in Hong Kong. C) increases in value against the U.S. dollar and the risk that interest rates increase in Hong Kong. Your answer: A was incorrect. The correct answer was C) increases in value against the U.S. dollar and the risk that interest rates increase in Hong Kong. The bank faces two problems. First, if the Hong Kong dollar increases in value, it will take more U.S. dollars to repay the Hong Kong depositors. Indeed, if the Hong Kong dollar increases significantly, it may take more U.S. dollars to repay the Hong Kong depositors than the bank makes on the U.S. loan. Secondly, if the interest rate in Hong Kong rises, the bank pays more in interest on its CDs while the rate on the bank’s U.S. loans does not change. In this case, interest expense would rise and interest income would remain the same, which narrows the bank’s profits.
Hey man! I don’t understand your thinking. Maybe you can understand these shortcuts. If there is an asset/liability in Country X, the asset’s/liability’s economic value rises if Country X’s currency appreciates, and falls if CountryX’s currency depreciates. This company’s assets are in the US, so dollar rising is good, dollar falling is bad This company’s liabilities are in HKD, so HKD rising is bad (liabilities increase in value) and HKD falling is good (liabilities decrease in value) Therefore, the currency risk is that HK dollar will appreciate versus the dollar. Yawn… Im so sleepy!
GTucker Wrote: ------------------------------------------------------- > I looked at the situation as the US Bank has > assets (ie. loans) denominated in US dollars and > liabilities denominated Hong Kong dollars. Then, > since the bank is using the CDs to fund its US > Dollar loans I reasoned that the bank had the risk > of the Hong Kong dollar depreciating against the > US dollar, thus making the US dollar more > expensive and decreasing the amount of loans the > bank can make (ie. decrease asset value). Like I > said before, the explanation below does make > sense, but I was really hoping someone could tell > me why my thought process is wrong. Thanks > Everything is correct in this thought process except that you need take care of future cashflows and not current cashflows. You are saying that if HKD depreciates, it will need more of HKD to fund USD loans. Correct. But this has already happened. HKD CDs have already funded USD loans. What we need to mitigate now is our future liability of paying back on HKD CDs. That risk comes when HKD appreciates in future and more USD would be needed to pay back that liability. I think you already got the interest rate part. Hope it clarifies.
Had great timing with beatthecfa in posting 
I guess the 2 posts together should reduce the risk of any remaining uncertainity on clarification
Not sure if this is a right way to think about the process. But let me try. If a bank has an asset and liability, it would make more sense that the bank would be more concern about paying its liability. Since the asset is in USD, liability in HKD, the bank would want to ensure that the interest it receive from the asset in USD will be able to pay off the interest to the liability in HKD. In this case, if the HKD appreciate, the bank would need more USD to pay the same amount of interest on its CDs as before. I understand your concern since the question state that the bank was taking in CDs to fund its USD loan. But I would assume that US loan is a lump sum amount at initiation and the bank is only concern about future interest payment. Hopes for more discussion and thanks for bringing this up. Forex is my Achilles’ heel.
damn I could have made it into a threesome if not for some European bank’s call to solicit personal loan!
^ And yes, your thinking is correct. The risk of needing more USD to pay HKD future interests, if HKD appreciates, also extends to when it is payback time for the HKD Principal. I think beatthecfa has put it in a simpler, more generalized and a easier to retain way.
Thanks for the feedback, really cleared things up for me.