ANALYZING BANK FINANCIAL PERFORMANCE OVERVIEW This session introduces bank financial statements and provides a traditional, ratio-based procedure for analyzing bank financial performance using historical data. It demonstrates the interrelationship between the income statement and balance sheet and describes the risk and return trade-off underlying management decisions. Data are provided that compare the performance characteristics of small banks versus large banks and differentiate between high and low performers. LEARNING OBJECTIVES Following the successful completion of this session, you should be able to: • recognize the basic balance sheet accounts and income statement components and understand how they relate to each other • apply the ROE model to analyzing bank profitability over time and against peers • comprehend the importance of net interest margin, earning assets, and operating efficiency as sources of bank profitability • identify key ratios that signify the degree of credit risk, liquidity risk, interest rate risk, and capital risk assumed by a bank • explain the factors that affect a bank's CAMELS rating • understand how and why the performance characteristics of small and large banks differ • relate key financial concepts and data to planning and managing a bank. 2 THE BALANCE SHEET A bank's balance sheet presents financial information that compares what a bank owns with what it owes and the ownership interest of stockholders. Assets represent what a bank owns; liabilities represent what a bank owes; and equity refers to stockholders' ownership such that: Assets = Liabilities + Equity The balance sheet represents a snapshot taken at a point in time. Account values indicate what a bank owns or owes on that date. Bank regulators require that banks report balance sheet data quarterly, so most published figures are dated at the end of March, June, September, and December of each year. Exhibit 2-1 presents balance sheet data for SCBS Bank, an $80 million community bank. Bank Assets Bank assets fall into one of four types, each with different yield and risk features. Cash and Due from Banks Cash and due from banks consists of vault cash, deposits held at Federal Reserve Banks (Fed), deposits held at other financial institutions, and checks in the process of collection. These accounts generally facilitate check clearing and customers' currency withdrawals and serve to meet legal reserve requirements. Their distinguishing feature is that they do not earn interest, although balances at the Fed and other depository institutions can be used to obtain correspondent banking services. Investments Investment securities are primarily fixed-income securities held to meet liquidity needs and earn interest. Short-term securities have maturities less than one year and can be readily sold if a bank needs cash and the securities are not pledged as collateral against a bank liability. In Exhibit 2-1, SCBS Bank reports owning time deposits issued by other

1. Chapter 2
The Market for
Foreign
Exchange
INTERNATIONAL MONETARY
AND
FINANCIAL ECONOMICS
Third Edition
Joseph P. Daniels
David D. VanHoose
Copyright © South-Western, a division of Thomson Learning. All rights reserved.

2. 2
The Foreign Exchange Market
• Exchange Rate
– The value of one currency relative to another
currency as the number of units of one currency
required to purchase one unit of the other currency.
• Foreign-Currency-Denominated Financial
Instrument
– A financial asset, such as a bond, a stock, or a bank
deposit, whose value is denominated in the
currency of another nation.

3. 3
Spot Market Characteristics
• It is the oldest and largest financial market in the world:
– Has no central trading floor where buyers and sellers meet.
– Is open twenty-four hours a day, except for short gaps on weekends.
– The spot market is a market for immediate delivery (2 to 3 days).
• Primarily an interbank market, which is the trading of foreign-
currency-denominated deposits between large banks.
– Global banks account for about two-thirds of the market volume, while
foreign exchange brokers and dealers account for approximately 20
percent.
• Approximately $US1.4 - 1.6 trillion daily in global
transactions.

4. 4
A Foreign Exchange Transaction
• Toshiba receives a
dollar denominated
payment from Best Buy,
which they present to
Fuji Bank.
• To exchange the dollar
payment for the yen
equivalent, Fuji Bank
may contact another
bank, such as Citigroup,
or contact a FX broker.

5. 5
Currency Trading Tables
• Typical FX tables in a daily business
publication provide spot and forward rates.
• US $ equivalent or US $ per currency is the
dollar price of a unit of foreign currency (eg.,
$/€).
• Currency per US $ is the foreign currency
price of one US dollar (eg., €/$).

6. 6
Some Additional Terminology:
Direct - Indirect Quotes
• Direct quote is the home currency price of a
foreign currency.
• Indirect quote is the foreign currency price
of the home currency.

7. 7
Appreciating and
Depreciating Currencies
• A currency that has lost value relative to another
currency is said to have depreciated.
• A currency that has gained value relative to another
currency is said to have appreciated.
• These terms relate to the market process and are
different from devaluation and revaluation (Chapter
3).

8. 8
Appreciating and
Depreciating Currencies
• We use the percentage change formula to calculate
the amount of appreciation or depreciation.
• Example, suppose on Monday the Mexican peso
traded at 11.3855 MXN/USD, whereas on Tuesday it
traded at 11.1245 MXN/USD.
• The peso has appreciated, as it now takes fewer pesos
to purchase each dollar.
• The amount of appreciation is:
[(11.1245 – 11.3855)/11.3855] •100 = -2.29%

9. 9
Cross-Rates: Unobserved Rates
• A cross-rate is an unobserved rate that is
calculated from two observed rates.
• For example, the spot rate for the Canadian
dollar is 1.3176 C$/$, and the spot rate on the
euro is 1.2153 $/€. What is the Canadian dollar
price of the euro (C$/€)?
• Note that (C$/$)·($/€) = C$/€.
• In this example, (1.3176)· (1.2153) = 1.6013
C$/€.

10. 10
Bid - Ask Spreads
• The bid is the price the bank is willing to pay for
the currency, e.g., 1.2148 $/€ is the bid on the euro
in terms of the dollar.
• The ask is what the bank is willing to sell the
currency for, e.g. 1.2158 $/€, is the ask on the euro
in terms of the dollar.
• The typical rate quoted in a daily publication is the
midpoint of these two values, e.g., 1.2153.

11. 11
Bid - Ask Spread and Margin
• The bid - ask spread of a currency reflects, in general, the
cost of transacting in that currency.
• It is calculated as the difference between the ask and the
bid.
• For example, 1.2158 – 1.2148 = 0.001.
• The bid - ask spread can be converted into a percent to
compare the cost of transacting among a number of
currencies.
• The margin is calculated as the spread as a percent of the
ask.
(Ask - Bid)/Ask * 100
• Example, (1.2158 – 1.2148)/1.2158 * 100 = 0.082%.

12. 12
Real Exchange Rates
Real Measures
• Nominal variables, such as an exchange
rate, do not consider changes in prices over
time.
• Real variables, on the other hand,
compensate for price changes.
• A real exchange rate, therefore, accounts
for relative price changes, or in other
words, for differences in inflation between
the two nations.

13. 13
Real Exchange Rates
• A nominal exchange rate indicates the rate of
exchange between one nation’s currency with the
currency of another nation.
• Real exchange rates indicate the purchasing power of
a nation’s residents for foreign goods and services
relative to their purchasing power for domestic
goods and services.
• A real exchange rate is an index. Hence, we
compare its value for one period relative to its value
in another period, or the change in the index from
one period to another.

14. 14
Real Exchange Rates
An Example
• In 1990 the spot rate between the dollar and the peso
was 2.9454 (MXN/$).
• In 1995 the rate was 7.6425.
• Hence, the peso depreciated relative to the dollar by
159.5 percent {[(7.6425-2.9454)/2.9454]*100}.
• Based on this alone, the purchasing power of US
residents for Mexican goods and services (relative to
US goods and services) rose by 159 percent.

15. 15
Example: Continued
• In 1990 the Mexican CPI was 100 and the US CPI
was 100. In 1995, the CPI’s were 224.5 and 116.8
respectively.
• Based on this, Mexican prices rose 124.5 percent
while US prices rose 16.8 percent, a 107.7
difference.
• Since the prices of Mexican goods and services
rose faster than the prices of US goods and
services, there was a decline in purchasing power
over Mexican goods and services relative to the
purchasing power over US goods and services.

16. 16
Combining the Two Effects
• A real exchange rate combines these two effects -
the gain in purchasing power of US residents due
to the nominal depreciation of the peso and the
decline in relative purchasing power due to
Mexican prices rising at a faster rate than US
prices.
• To construct a real exchange rate, the spot rate, as
it is quoted here, is multiplied by the ratio of the
US CPI to the Mexican CPI.
(MXN/$) • (CPIUS/CPIMX)

17. 17
Combining the Two Effects
• 1990 Real Rate = 2.9454 x (100/100) =
2.9454.
• 1995 Real Rate = 7.6425 x (116.8/224.5) =
3.9761.
• The real depreciation of the peso was
34.99 percent.

18. 18
Conclusion
• The nominal exchange rate change resulted in a
159.5 percent gain in the purchasing power of
Mexican goods and services for US residents.
• The difference in price changes resulted in a 107.7
percent loss of purchasing power of Mexican goods
and services relative to US goods and services for
US residents.
• Note how the 159.5 percent gain was partially offset
by the 107.7 loss, resulting in an overall 35 percent
gain in purchasing power.

19. 19
Effective Exchange Rates
• On any given day, a currency may appreciate in
value relative to some currencies while depreciating
in value against others.
• An effective exchange rate is a measure of the
weighted-average value of a currency relative to a
select group of currencies.
• Thus, it is a guide to the general value of the
currency.

20. 20
Weighted Average Value
• To construct an EER, we must first pick a set of
currencies we are most interested in.
• Next, we must assign relative weights. In the
following example, we weight the currency
according to the country’s importance as a trading
partner.

21. 21
Weights
• Suppose that of all the trade of the US with
Canada, Mexico, and the UK, Canada accounts
for 50 percent, Mexico for 30 percent, and the
UK for 20 percent.
• These constitute our weights (0.50, 0.30, and
0.20).
• Now consider the following exchange rate
data.

22. 22
Exchange Rate Data
Currency 2004 Value 2003 Value
Canadian Dollar 1.31 $C/$ 1.39
Mexican Peso 11.4 P/$ 10.9
British Pound 0.56 £/$ 0.64

23. 23
Calculating the EER
• The EER is calculating by summing the weighted
values of the current period rate relative to the base
year rate.
• The weighted-average value is calculated as:
Σ[(Weight i)(current exchange value i)/(base exchange value i)]
Where i represents each individual country
included in the weighted average.

24. 24
Calculating the EER
• Commonly this sum is multiplied by 100 to
express the EER on a 100 basis.
• As we shall see next, the base-year value of an
index measure is 100.
• The index, therefore, is useful is showing
changes in the weighted average value from
one period to another.

25. 25
Example
• Let 2003 be the base year.
• The effective exchange rate for 2003 was:
[(1.39/1.39)•0.50 + (10.9/10.9)•0.30
+ (0.64/.64)•0.20]•100
= 100.
• As with any index measure, the base year
value is 100.

26. 26
Example
• The value of the EER for 2004 is:
[(1.31/1.39)•0.50 + (11.4/10.9)•0.30
+ (0.56/0.64)•0.20] • 100
• Or 96.0
• The dollar, therefore, has experienced a 4
percent depreciation in weighted value.

27. 27
Effective Exchange Measures
• There are a number of effective exchange
measures available in the popular press. Some
common measures are:
• Bank of England Index: The Economist and
Financial Times.
• J.P. Morgan: The Wall Street Journal.
• International Monetary Fund, International
Financial Statistics.

28. 28
Effective Exchange Rates
Japan, United Kingdom, United States
Between 1985 and 1995,
the average value of the
U.S. dollar and the British
pound declined, while the
average value of the
Japanese yen increased.
This trend reversed in
1995, but began anew in
2002.
SOURCE: Data from the Bank of England.

29. 29
Arbitrage:
Consistency of Cross Rates
• Arbitrage is the simultaneous buying and selling to
profit (as opposed to speculation).
• The ability of market participants to arbitrage
guarantees that cross rates will be, in general,
consistent.
• If a cross rate is not consistent, the actions of
currency traders (arbitrage) will bring the respective
currencies in line.

30. 30
Spatial Arbitrage
• Spatial Arbitrage refers to buying a
currency in one market and selling it in
another.
• Price differences arise from geographical
(spatial) dispersed markets.
• Due to the low-cost rapid-information
nature of the foreign exchange market,
these prices differences are arbitraged
away quickly.

31. 31
Triangular Arbitrage
• Triangular arbitrage involves a third
currency and/or market.
• Arbitrage opportunities exist if an observed
rate in another market is not consistent with
a cross-rate (ignoring transaction costs).
• Again, profit opportunities are likely to be
arbitraged away quickly, meaning that
cross-rates are, for the most part, consistent
with observed rates.

32. 32
Triangular Arbitrage: Example
• The US dollar is trading for 1.7936 ($/£) and
the Polish zloty for 6.5492 (Z/£) in London,
while the zloty is trading for 3.7826 (Z/$) in
New York.
• The cross-rate in London is:
6.5492/1.7936 = 3.6514 (Z/$)
• Hence, an arbitrage opportunity exists.

33. 33
Example Continued
• A trader with £1, could buy $1.7936 in London.
• The $1.7936 would purchase Z6.7845 in New
York.
• The Z6.7845 purchases £1.0359 in London.
This is a profit of £0.0359 or 3.59 percent profit
on the transaction.
• To understand the arbitrage opportunity,
remember “buy low, sell high.”

34. 34
Triangular Arbitrage
Buy $ in London
Purchase Z in New York
Purchase £ in London

35. 35
The Demand for a Currency
• The demand for a currency is a derived
demand. That is, the demand for the currency
is derived from the demand for the goods,
services, and financial assets the currency is
used to purchase.
• If, for example, foreign demand for European
goods and services increases, the demand for
the euro increases.

36. 36
The Demand Curve is
Downward Sloping
• If, for example, the euro depreciates, European
goods, services, and financial assets become less
expensive to foreign residents. Foreign residents will
increase their quantity demanded of the euro to
purchase more European goods, services, and
financial assets.
• The downward slope of the demand curve shows the
negative relationship between the exchange rate and
the quantity demanded.

37. 37
The Demand Curve
The downward slope of the
demand curve shows the
negative relationship
between the exchange rate
and the quantity demanded.

38. 38
Important Note
• It is vital to construct and label supply and demand
diagrams properly.
• Note here we are diagramming the market for the
euro. Hence, it is crucial to represent the correct
exchange rate on the vertical axis.
• The correct exchange rate is one that reflects the
“price” of the euro. That is, it must be an indirect
quote.

39. 39
An Increase in Demand
• Consider an increase in the demand for the euro.
• Suppose, for example, that savers desire euro-
denominated financial assets relative to dollar-
denominated financial assets because of a change in
economic conditions.
• The demand for the euro rises as savers desire more
euros to purchase greater amounts of European
financial assets.

40. 40
An Increase in the Demand
for the Euro
The demand for the
euro rises as savers
desire more euros to
purchase greater
amounts of European
financial assets.

41. 41
The Supply of a Currency
• The supply of one currency is derived from the
demand for another currency.
• Consider the demand schedule for the dollar. If the
dollar depreciates relative to the euro, there is an
increase in the quantity demanded of dollars.
• As more dollars are purchased, the quantity of euros
supplied in the foreign exchange market increases.

42. 42
The Supply of the Euro
Consider the demand schedule for the dollar. If the dollar depreciates relative to
the euro, there is an increase in the quantity demanded of dollars. As more
dollars are purchased, the quantity of euros supplied in the foreign exchange
market increases.

43. 43
An Increase in the Supply of the Euro
An increase in the demand
for the U.S. dollar by
German residents leads to an
increase in the supply of the
euro.

44. 44
Equilibrium
• The market is in equilibrium when the quantity
supplied of a currency is equal to the quantity
demanded.
• The equilibrium rate of exchange is also
referred to as the market clearing exchange
rate because there is neither a surplus nor a
shortage of the currency.

45. 45
Market Equilibrium
At exchange rate Sb the
quantity supplied of the euro
exceeds the quantity demanded
and the euro will depreciate.
At exchange rate Sc, the
quantity of euros demanded
exceeds the quantity supplied
and the euro will appreciate.

46. 46
Increase in the Demand for the Euro
An increase in U.S. consumers’
demand for German goods results
in an increase in the demand for the
euro. The euro appreciates relative
to the dollar.

47. 47
Central Bank Intervention
• Suppose a nation’s policymakers desire to keep the
value of the currency stable (relative to the currency
of an important partner).
• They may request the central bank to intervene in
foreign exchange (FX) markets.
• Basically, FX intervention entails the buying and
selling of foreign reserves (foreign currency
denominated financial instruments).

48. 48
FX Intervention - Continued
• Let’s continue with the previous
example and assume that there is
an increase in the demand for
the euro.
• As shown, the demand curve for
the euro shifts to the right,
resulting in an appreciation of
the euro relative to the dollar.

49. 49
FX Intervention - Continued
• Now let’s suppose that the European Central
Bank (ECB) desires to maintain the value of
the euro at Se rather than the market
determined rate S'.
• The ECB would need to accommodate the
increase in demand for the euro with an
equivalent increase in the quantity of euros
supplied.

50. 50
Buying and Selling Foreign Reserves
• Suppose the ECB buys dollar-denominated deposits
from commercial banks. (In effect, the ECB is
removing these dollars from circulation.)
• The ECB must pay the banks for the dollar-
denominated financial instruments it bought from
them.
• The ECB pays the banks with euro-denominated
deposits – increasing the quantity of euros supplied.

51. 51
FX Intervention
The ECB accommodates the
increase in the demand for
the euro by increasing the
quantity supplied of the euro
via a purchase of dollar-
denominated financial
instruments.

52. 52
FX Intervention - Conclusion
• The increase in the quantity of euros supplied
accommodates the increase in the demand for
the euro.
• The exchange rate remains at Se.
• The quantity transacted, however, rises to Q2.
• The amount (euro value) of the intervention is
given by difference between Q‘
d and Qe.

53. 53
Over and Under-Valued Currencies
• If a currency’s value is market determined,
how can it be over- or under-valued?
• A currency is said to be over- or under-valued
if the market exchange rate is different from
the rate that a model or individual predicts to
be the “correct” rate.
• In other words, the individual believes the
market “has it wrong.”

54. 54
Undervalued
• Suppose your predicted
spot value, Sb, lies
above the market
determined rate, Se.
• Hence, you believe it
should take a greater
amount of dollars to
buy each euro. You
would conclude,
therefore, that euro is
undervalued.

55. 55
Purchasing Power Parity
Absolute or the Law of One Price
• Suppose The Economist magazine sells for £2.50 in
the UK and $3.95 in the US.
• Arbitrage, therefore, should guarantee that the
exchange rate between the dollar and the pound to
be s = 3.95/2.50 = 1.580 ($/£).
• In words, the dollar price of The Economist in the
UK should equal the dollar price of the Economist
in the US (ignoring transportation costs).

56. 56
Absolute PPP
• Absolute PPP is expressed as P = P*×S, where
P is the domestic price, P* is the foreign price,
and S is the spot rate, expressed as domestic to
foreign currency units.
• Often it is rearranged as: S = P/P*.
• The previous slide was an example of absolute
PPP.

57. 57
Relative PPP
• Rearrange APPP to S = P/P*.
• Often economists will take the log of this expression
to obtain: S =  - *.
• In words, domestic inflation less foreign inflation
should equal the change in the spot rate.
• Relative PPP implies that the higher inflation country
should see its currency depreciate.
• This is the version that economists would test.