Hedging foreign currency risks
This page contains information on the impact of climate change on New Zealand's financial system from the May 2019 Financial Stability Report.
Banks hedge their foreign currency exposures using a range of derivative contracts. When a bank uses one of these contracts to hedge foreign currency borrowing, it agrees with its derivative counterparty to exchange New Zealand dollars for foreign currency at a future date and at a predetermined exchange rate. A bank can match the amount of foreign currency and the date of the future exchange in a contract to the principal amount and maturity of the bank’s foreign currency borrowing. This matching transaction effectively transforms a bank’s foreign currency borrowing into New Zealand dollar borrowing.
Although hedging through derivatives mostly eliminates foreign currency risk, it can create some additional risks that banks must monitor and manage:
- A bank’s derivative counterparty could fail and not make good on its promise, causing a loss to the bank. Counterparties mitigate this risk by requiring each other to provide collateral when a derivative has positive value for them.
- Banks could face demands for large amounts of collateral, if the New Zealand dollar appreciates significantly.
- When they need to roll over funding, banks may be unable to find a hedging counterparty or the cost of hedging could increase, if conditions in financial markets deteriorate.
- Banks could face losses if their hedges are imperfect or if a derivative does not function as intended.