How Do Foreign Currency Loans Work to Hedge?
Foreign currency loans can work as a useful hedge against various foreign currency risks. They can also be hedged through a variety of standard financial instruments. This allows investors in foreign currency loans to focus on making good loans, rather than spending their time on macroeconomic factors that lead to currency fluctuations.
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Who Makes Foreign Currency Loans?
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Foreign currency loans are often made by international banks, or banks that have deposits from foreign countries, in foreign currencies. Often, a bank may find it easiest to raise assets in a country with a high savings rate such as China or Japan, but may find more interesting investments in another country such as Brazil or Russia. In this case, the bank is likely to lend money to foreign companies, and denominate the loan in the borrower's local currency.
Why Are These Loans Hedged?
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These loans create a currency risk for the lender. For example, if a bank in the United States borrowed dollars and lent pesos to a Mexican firm, it might make money on the interest but lose money if the value of the peso dropped. To avoid this risk, these banks hedge their loans. The most common hedge is a currency swap, which is a promise to deliver a certain amount of a currency on a particular date, at a particular exchange rate. Banks will create a currency swap with another company that is either speculating on currencies or trying to hedge the opposite currency trade. This mitigates most currency risk.
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How Can These Loans Act as Hedges?
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These loans themselves can be used as hedges in the same circumstance. For example, a bank that borrowed dollars in order to make loans in pesos could borrow pesos and make loans in dollars. If the loans were equal in size, the currency risk would be zero. Any fluctuation in exchange rates would be cancelled out. A bank can also get the same effect by buying bonds in the appropriate currency. This may be more cost-effective.
Settling Hedges
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When these hedges are created, they need to be settled. Settlement occurs when all obligations to all parties end. That means the loan has been repaid and the swap has ended. This kind of settlement can be expedited by creating a swap that is timed to coincide with payments on the loan, so that when the loan is over, the swap expires. This can also be done by trading in the currency market and executing trades to reduce exposure as the loan is paid back.
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References
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