Mortgage is simply defined as a type of secured loan used to purchase a home, land or other

types of rental properties. They are loans that the property being purchased serves as collateral

for. The four major categories of mortgage include:

 Conventional Mortgage: It is the most common type of mortgage issued by banks and

other financial institution to burrowers with high credit score and stable income source,

and aren’t guaranteed by any government institutions. It makes up the largest share of

mortgage market, approximately 60% of all mortgages.

 Government-backed Mortgage: It is the type of mortgage backed or guaranteed by

government institutions to risk the risk of default for lender. It included three types:

Federal Housing Administration (FHA) mortgage, Veterans Affairs (VA) Mortgage, and

U.S. Department of Agriculture (USDA) mortgage, accounting for approximately 35% of

the overall mortgage market in total.

 Jumbo Mortgage: It is the type of mortgage exceeding the loan limits set by Fannie Mae

and Freddie Mac and issued to borrowers with good credit score and large down

payment. Jumbo mortgages account for around 5% of the overall mortgage market.

 Adjustable-rate Mortgage (ARM): It is the type of mortgage with fluctuating interest

rates cover period of 5,7 or 10 years. It is also issued to borrowers with good credit score

and stable income source. ARMs make up around 10% of the overall mortgage market.

Collateralized mortgage obligation (CMO) is a type of mortgage-backed security (MBS)

created by banks or other financial institutions by pooling together a group of individual

mortgages, which is later divided into smaller units called ‘tranches’ representing unique

characteristics and varying risks (Fuster et al., 2022 ). The tranches are generally denoted by A,

B, C and so on, where A represents a senior tranche with least amount of risk and other
following tranches represent increasing risks. The tranches are then allocated in priority risk for

receiving cash flows with Tranche A having the first claim on cash flows followed by Tranche B

and C respectively. The tranches receive their respective payment after mortgage payment are

made by burrowers according to priority ratings and are finally sold to suitable investors based

on their risk appetite and desired return. A CMO enables investors to select an

investment section which aligns with their investment goals by generating tranches with various

risks and return levels.

A mortgage-backed bond (MBB) is a type of bond that consist multiple home loans issued by

the bank as collateral. Mortgage-backed bonds allow financial institutions to turn untradeable

home loans into tradable securities, increasing liquidity (Fuster et al., 2022). Also, financial

institutions may transfer the risk associated with those loans to investors by securitizing

mortgage loans. For instance, a bank might combine a group of mortgage loans into MBBs and

sell them to investors to raise money; thus transferring the risk of default to investors. Likewise,

financial institutions can use MBBs to help them comply with regulatory capital requirements by

structuring them in certain ways like raising their capital ratios (Fuster et al., 2022 ). Also,

MBBs provide investors with exposure to mortgage market unlike traditional bonds; helping

them diversify their portfolios.

If the Swiss franc is expected to depreciate relative to the U.S. dollar in the near future, a

U.S.-based FI in Bern City would prefer to be net long in its asset positions as it indicated FI

holding more assets denominated in U.S. dollars than in Swiss francs. For instance, let us assume

that the FI has a portfolio made up of 60% assets denominated in Swiss francs and 40% assets

denominated in US dollars. If the Swiss franc is predicted to depreciate, The FI would raise its

exposure to assets denominated in U.S. dollars and lower its exposure to assets denominated in
Swiss francs which would result in a portfolio containing a greater proportion of assets

denominated in US dollars, making the FI net long in US dollars. This approach would help the

FI if the U.S. dollar appreciated against other currencies as well as protect it from any losses

caused by Swiss franc devaluation.

According to the question, the insurance company has invested $1,000,000 in British bond

that pays £300 in interest per year for 20 years. If the current investment rate is £1.364/$, the

investment is worth £729,927.27 currently. The value of investment will change with change in

exchange rate; hence, the risk faced by the insurance company is transaction risk. As the

insurance company needs to convert £300 to get annual interest payment in US$, the insurance

firm would incur a loss if the exchange rate changed unfavorably since they would get fewer

money than they expected. If the exchange rate shifts in favor of pound, the insurance company

would incur loss as they would receive fewer dollars for each pound. However, if the exchange

rate shifts in favor of dollar, the insurance company would benefit as they would receive more

dollars for each pound.

The spot market for foreign exchange (FX) refers to the market where financial instruments

are traded for immediate delivery. It involves the exchange of one currency for another at the

current exchange rate. The foreign exchange market's spot market is the most liquid and

frequently traded area, and serves as a framework for valuing currencies (Cornell, 1977).

Likewise, the forward market for foreign exchange (FX) refers to the market where financial

instruments are traded for future delivery. It involves exchange of currency on a future date at an

agreed-upon exchange rate, known as the forward rate (Cornell, 1977). This enables traders to

control their exposure to exchange rate risk and hedge against anticipated currency fluctuations.

Similarly, being net long in a currency means that an entity hold larger of a currency in their
possession than they have sold or traded, with a expectation that the value of currency would

rise. For instance, if an investor holds $10,000 worth of Korean won and has not sold or

exchanged any of it, they are considered net long in the Korean won.

Managers of foreign investments (FI) have a variety of reasons for hedging their foreign

exchange risks. Reducing the risk of financial loss and stabilizing cash flows are major reasons

for hedging foreign currency risks as value of foreign investments can be greatly impacted by

changes in currency exchange rates; affecting the overall financial stability of the portfolio. For

instance, if a FI invests in a foreign stock market but anticipates a decline in the value of the

local currency, they may use alternatives to secure a favorable exchange rate or sell futures

contracts to reduce their exposure. However, hedging foreign currency exposure involves costs

and risks related to protection and execution. Since hedging foreign currency involves various

expenses, it could reduce the portfolio's overall returns if not managed effectively. Likewise,

hedging foreign currency exposures may not offer total protection due to factors like basis risk,

liquidity risk, and counterparty risk (Jayasekara, 2014). Also, hedging currency requires

knowledge of financial derivatives, and risk management strategies which could result in

complexities in case of carelessness and errors.

The two primary methods of hedging FX risk for an FI are on-balance-sheet hedging and off-

balance-sheet hedging. On-balance-sheet hedging refers to the process of using the same

currency on the asset and liability sides of the balance sheet to achieve a perfect hedge, through

method like matching cash flows, and issuing debt in the same currency as assets. On the other

hand, Off-balance-sheet hedging refers to the process of using monetary instruments like forward

contracts, options, and exchanges to reduce FX risk. This type of hedging does not necessitate

matching currencies, but instead emphasizes on reducing its exposure to fluctuations in exchange
rates (Jayasekara, 2014). To achieve a perfect hedge through on-balance-sheet hedging, a FX

rate must be fixed prior to executing the hedging. Also, the currency, quantity, and maturity of

the hedge must all be properly matched as any mismatch could result in residual FX risk

(Jayasekara, 2014). The advantages of using an off-balance-sheet hedging included flexibility

and the potential to construct a perfect hedge as it allows FIs to benefit from positive exchange

rate movements and customize their hedging strategies to meet their specific needs. However, it

can be more complicated and opaque as (FIs) might not all have the knowledge and skills

necessary to deploy financial services. Also, it can be relatively expensive as it involves

transaction costs in form of fees and spreads.

If international capital markets are well integrated and operate efficiently, financial

institutions (FIs) can still be exposed to foreign exchange risk in cases of cross-border

transactions, hedging inefficiencies and policy changes by government. For instance, if a FI

exports goods to a foreign nation, the value of the transaction would be diminished by any

depreciation of the foreign currency in relation to the FI's home currency. Likewise, the major

sources of foreign exchange risk for FIs involve translation risk, economic risk and counterparty

risk. For instance, if a bank with headquarters in the United Kingdom has a subsidiary in

Japan and the pound sterling depreciates against the Yen, the translated value of the profits of the

subsidiary will decline. Likewise, FIs could also face economic risks due to factors like inflation

and political instability could cause fluctuation in exchange rates.

Purchasing power parity (PPP) theory is an economic theory that takes into account the

relative costs of products and services across nations in an effort to balance the purchasing power

of various currencies. The PPP theorem states that, in the absence of trade restrictions and

transportation expenses, the exchange rate between two currencies should be altered to account
for the differences in the levels of prices between the two nations (Terborgh, 1926). The

hypothesis is based on the notion that the price of a basket of products should be the same across

nations when represented in a common currency (Terborgh, 1926). For instance, let us consider

that a basket of good costs $20 in County A and costs 200 units in County B. the rate of

exchange is $20 per 200 units of currency B i.ee 0.2 units of currency A is exchanged for one

unit of currency B. The PPP theorem states that in order to guarantee purchasing power parity,

the exchange rate between Currency A and Currency B should be 0.1 units of Currency A for

every unit of Currency B.

References

Cornell, B. (1977). Spot rates, forward rates and exchange market efficiency. Journal of

Financial Economics, 5(1), 55-65. https://doi.org/10.1016/0304-405x(77)90029-0

Fuster, A., Lucca, D. O., & Vickery, J. I. (2022). Mortgage-Backed Securities. SSRN Electronic

Journal. https://dx.doi.org/10.2139/ssrn.4026234

Iyandemye, S., Barayandema, J., & Gasheja, F. (2018). Mortgage finance market and housing

affordability in urban areas in Rwanda: A case of Kigali city. Journal for the

Advancement of Developing Economies, 7(1), 41-58.

https://doi.org/10.32873/unl.dc.jade7.1.4

Jayasekara, S. G. (2014). Foreign exchange risk and hedging. Certified Management

Accountant, 4, 34-37.

https://www.researchgate.net/publication/

301651893_Foreign_exchange_risk_and_hedging

Terborgh, G. W. (1926). The Purchasing-Power Parity Theory. Journal of Political Economy,

34(2), 197-208. https://www.jstor.org/stable/pdf/1819928.pdf