Intraday Patterns in Fx Returns and Order Flow

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Reserve Bank of Australia

RESEARCH DISCUSSION PAPER
Limiting Foreign Exchange Exposure through Hedging: The Australian Experience Chris Becker and Daniel Fabbro RDP 2006-09

LIMITING FOREIGN EXCHANGE EXPOSURE THROUGH HEDGING: THE AUSTRALIAN EXPERIENCE

Chris Becker and Daniel Fabbro

Research Discussion Paper 2006-09

August 2006 International Department Reserve Bank of Australia

We acknowledge the research assistance of Bronwyn Kenna and are grateful to Guy Debelle, Christopher Kent, Michael Sinclair, Jonathan Kearns, Tim Hampton, and other colleagues at the Reserve Bank of Australia for their helpful comments. Any remaining errors are our own. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Reserve Bank of Australia. Authors: beckerc@rba.gov.au, fabbrod@rba.gov.au Economic Publications: ecpubs@rba.gov.au

Abstract
The Australian economy has proven resilient to sizable exchange rate fluctuations over the post-float period. In part this can be attributed to financial institutions and non-financial firms learning to adapt to swings in the Australian dollar. This has included the increased use of financial derivative contracts to hedge their foreign exchange exposures. This paper examines the available evidence on the nature and extent of this hedging behaviour. Related to this, Australia’s net foreign liability position is often cited as a vulnerability of the Australian economy to exchange rate depreciation. We show this not to be the case because much of the liability position is denominated in local currency terms. In fact, the amount of liabilities denominated in foreign currency is less than the amount of foreign currency assets held by residents.

JEL Classification Numbers: F21, F31, F41 Keywords: hedging, foreign currency exposure, derivatives

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Table of Contents
1. 2. Introduction Hedging Instruments 2.1 2.2 Natural Hedging Foreign Exchange Derivatives 2.2.1 Outright foreign exchange forward contracts 2.2.2 Cross-currency interest rate swaps 2.2.3 Foreign exchange options 1 3 4 6 6 8 10 11 12 14 16 17 18 19 22 24 26 28 28 30

3.

Hedging Practices in Australia 3.1 3.2 3.3 3.4 Adapting to Exchange Rate Fluctuations What Hedges are in Place? Time Horizon of Firms’ Hedging Foreign Currency Exposure is Predominantly to the US Dollar

4.

Measuring Foreign Currency Exposure 4.1 4.2 4.3 Gross Foreign Assets and Liabilities International Adjustment Augmented for Hedging Practices Residual Risks to Consider

5.

Conclusion

Appendix A: Foreign Currency Exposure of the United States A.1 References Gross Foreign Assets and Liabilities

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LIMITING FOREIGN EXCHANGE EXPOSURE THROUGH HEDGING: THE AUSTRALIAN EXPERIENCE

Chris Becker and Daniel Fabbro

1.

Introduction

Exchange rate variations over time are a potential source of risk to cross-border financial obligations and trade-related transactions. Concern about the potentially disruptive financial and real consequences of such variations are reflected in the policy of some countries to explicitly limit the nominal variability of their currency vis-à-vis that of others. While this ‘fear of floating’ is the result of a complicated array of competing considerations, it nonetheless illustrates that limiting exchange rate variability ranks well ahead of other policy objectives in some countries. 1 Since the Australian dollar was floated in December 1983, the economy has proven to be resilient to substantial exchange rate fluctuations. Arguably, this resilience has strengthened over time, as firms have learned to adapt to exchange rate variability, including through the development of the hedging practices of financial institutions and non-financial firms. This paper examines foreign exchange hedging of direct balance sheet and transaction exposures and assesses their broader implications for the Australian economy. We draw on the quantitative results of Australian...
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