LO 77.4: Describe the implications of a stronger US dollar on financial stability

LO 77.4: Describe the implications of a stronger US dollar on financial stability and the real economy.
While the impact of a stronger dollar has been extensively discussed, the impact on the balance sheet of financial institutions is less well known. With a change in the dollar, both an institutions asset and liability values will change. A weaker dollar will benefit liabilities (make them smaller), while a stronger dollar will negatively impact liabilities (make them larger). To take the simple example of an emerging market company with dollar liabilities but domestic currency assets (we call this a naked currency mismatch), a weaker dollar will erode the value of the liabilities, thereby positively impacting the balance sheet position of the entity, reducing tail risk. This would allow the entity to borrow more in capital markets. Conversely, a stronger dollar increases the value of liabilities, thereby increasing tail risk and negatively impacting the balance sheet and credit borrowing capacity. As a result, a dollar appreciation is often accompanied by a decline in global dollar lending activities.
For global banks that provide both dollar lending (which requires them to borrow dollars) as well as domestic hedging services, an increase in risk on the lending side will reduce their capacity to provide hedging services to domestic institutional clients.
It is important to recognize that the strengthening and weakening of the dollar has opposite impacts in the export and lending markets. A foreign currency appreciation (domestic currency depreciation) is positive for economic activity in the export market, but is negative in the borrowing market as it erodes the strength of the balance sheet.
In t e r n a t io n a l D o l l a r Le n d in g
The dollar lending in international markets reflects changes in the size of balance sheets and is a good proxy for risk appetite and leverage. In response to a dollar appreciation, bank lending in dollars will decline, reducing banks hedging activities to institutional players. This creates a demand-supply imbalance and raises the cost of hedging, and will also result in wider divergences from CIR
When calculating the dollar credit by banks to an international borrower, it is important to look at bank lenders in all international markets, not just U.S. lenders. For example, European banks have historically been one of the largest dollar lenders to Asian borrowers and have played an important role in dollar intermediation. As a result, when assessing the total dollar credit to Asian borrowers, it is important to look at not only U.S. lenders but also European and other international lenders.
Volatility and changes in the dollar have important implications for the stability of financial markets and for the real economy. As banks reduce their intermediation activities in response to rising volatility, they would inadvertently magnify shocks, rather than absorb them. Furthermore, because the dollar now reflects global risk appetite, a strengthening dollar truly has global implications.
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Topic 77 Cross Reference to GARP Assigned Reading – Shin
Ke y Co n c e pt s
LO 77.1 A key takeaway in the post financial crisis period is that the link between banks and capital markets is now global.
LO 77.2 External market factors and wholesale creditor sentiment can cause forced deleveraging.
The VIX, which measures implied volatility and is a fear gauge, was a reliable measure of leverage prior to the financial crisis. High VIX implied low leverage, and low VIX implied high leverage.
In the post-crisis period, the VIX lost its predictive ability. Attempted explanations of this change include monetary easing, regulations, and higher bank capitalizations.
Covered interest parity (CIP) is a parity condition that states that the interest rates implied in foreign exchange markets should be consistent with the money market rate for each currency. If CIP does not hold an arbitrage opportunity exists. CIP held up well before the financial crisis but it has not worked well in the post-crisis period, creating a persistent gap between CIP-implied rates and observed rates.
LO 77.3 In the post-crisis years, the U.S. dollar replaced the VIX as a more reliable measure of leverage. During periods of a strong dollar, risk appetite is weak. A period of a strong dollar also implies a wider cross-currency basis, raising the incremental cost of borrowing in dollars. The dollar also effectively prices the CIP deviation.
The fluctuation in the cross-currency basis implies an opportunity cost and could be seen as a pressure of forced deleveraging.
The higher return in recent years of dollar assets increased the demand for dollars. To hedge the volatility of the dollar, international investors hedge any dollar currency risk through banks, which in turn hedge their own risk by borrowing in dollars. The global dollar intermediation will mirror currency hedging demands.
LO 77.4 Changes in the value of the dollar will affect an institutions asset and liability values. A stronger dollar will increase dollar liabilities, thereby increasing tail risk and negatively impacting an institutions balance sheet and credit borrowing capacity. A dollar appreciation is often accompanied by a decline in global dollar lending activities.
In response to a dollar appreciation, banks dollar lending will fall, reducing their hedging activities. This creates a demand-supply imbalance and raises the cost of hedging.
2018 Kaplan, Inc.
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Topic 77 Cross Reference to GARP Assigned Reading – Shin
Given the size of dollar lending by non-U.S. entities, it is important to factor in the dollar lending of all international lenders when calculating the dollar credit by banks to international borrowers.
As banks reduce their intermediation activities in response to rising volatility, they may inadvertently magnify shocks.
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Topic 77 Cross Reference to GARP Assigned Reading – Shin
Co n c e pt Ch e c k e r s
A rise in the haircut from 3% to 3% for a security under a repo transaction implies that: A. B. C. D. leverage decreased to 20 times.
leverage increased by 2%. leverage increased to 20 times. leverage decreased by 2%.
Which of the following factors would most likely be associated with a low volatility index (VTX)? A. Low volatility, high leverage. B. Lack of borrowing activity. C. High volatility, low leverage. D. Low lending by global banks.
Which of the following statements regarding covered interest parity (CIP) is not correct? A. If CIP does not hold, market participants could make arbitrage profits. B. The principle of CIP holds that interest rates implied in foreign exchange
markets should be consistent with spot short-term interest rates.
C. For currencies A (domestic) and B (foreign), CIP requires only the spot and forward exchange rates for A and B and the money market interest rate on A. D. CIP states that the forward and spot exchange differential on two currencies
should mimic the ratio of money market interest rates on these currencies.
Which of the following borrowers would likely benefit the most by a weaker dollar? A. Borrowers with dollar assets exceeding dollar liabilities. B. Borrowers with dollar liabilities exceeding dollar assets C. Borrowers with domestic (non-dollar) assets and dollar liabilities. D. Borrowers with dollar assets and domestic (non-dollar) liabilities.
Which of the following factors is most associated with a stronger dollar? A. Stronger balance sheet of dollar borrowers. B. Reduced tail risk in the borrowers credit portfolio. C. Less capacity for credit extension. D. Increased lending by creditors.
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Topic 77 Cross Reference to GARP Assigned Reading – Shin
Co n c e pt Ch e c k e r An s w e r s
1. D A rise in the haircut from 3% to 5% implies that entities can only borrow 95 cents on the
dollar, rather than the previous 97 cents. This implies a decline in leverage. Thus, the leverage factor declined from 33 times to 20 times.
2. A Because the VTX is a measure of implied volatility, a low VIX value implies low market
volatility. When volatility is low, leverage tends to high, with a large number of borrowers and lenders transacting in the market.
3. C For currencies A and B, CIP uses the spot and forward exchange rates for A and B and the
money market interest rate on both A and B (not just on A).
The other statements are all correct. If CIP holds, there are no arbitrage opportunities. If CIP doesnt hold, a market participant could make an arbitrage profit by borrowing money at the lower interest rate, lending money at the higher interest rate, and concurrently fully hedging currency risk.
4. C A weaker dollar lowers the value of both dollar liabilities and dollar assets. An entity with domestic (non-dollar) assets and dollar liabilities will benefit most, since the asset value would remain unaffected by the dollar weakening, but the liability value would fall. As a result, the entitys equity would increase.
5. C A stronger dollar increases the dollar liabilities of borrowers, which weakens their balance
sheet. As their balance sheet weakens, their demand for additional borrowing declines, reducing dollar lending activities in the market.
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The following is a review of the Current Issues in Financial Markets principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Fi n Te c h C r e d i t : M a r k e t St r u c t u r e , Bu s i n e s s M o d e l s a n d Fi n a n c i a l St a b i l i t y Im pl i c a t i o n s
Topic 7 8
Ex a m Fo c u s
FinTech can be defined as technologically enabled financial innovation that could result in new business models, applications, processes or products with an associated material effect on financial markets, financial institutions, and the provision of financial services.1 This purely qualitative topic begins by providing details as to how FinTech credit markets could develop as well as possible impediments. For the exam, focus on the mechanics of the traditional P2P lending model and be able to compare and contrast it with other models. A thorough knowledge of both the micro and macro benefits and risks of FinTech credit markets is key to this topic.
Fin Te c h C r e d it M a r k e t s

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