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ABSTRACT

In this paper the risks and returns on U.S. banks' foreign currency positions are analyzed in a portfolio setting when both exchange rate and foreign interest rate risks are present. It is shown that U.S. banks could achieve considerable reductions in risk by optimally selecting their foreign currency positions. Actual foreign currency portfolio returns generated from expected exchange rate changes and exchange rate surprises were positive on average but those generated from interest rate surprises were negative. Although the total portfolio returns were positive, on a risk-adjusted basis bank return performance was relatively poor. Nevertheless, despite this relatively poor performance, the risk of ruin or failure for a “representative bank” from foreign currency activities was found to be approximately zero when judged in comparison to the capital funds available to large money center banks to cushion such losses.