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Canadian Commodity Prices and Exchange Rate Dynamics

Canadian Commodity Prices and Exchange Rate Dynamics: Evidence of Structural Change
1. Introduction
Canada is a small open economy and a large exporter of goods, services, and commodities. Coined as a “commodity currency” in 2003 by a paper written by Yu-chin Chen and Kenneth Rogoff, Canada has long held a comparative advantage in the distribution of natural resources and commodities. Due to the dependence of output growth in Canada on exports of natural resources and commodities to the world market, the Canadian dollar has long been considered to be representative of the state of production and exporting of commodities in Canada. Ultimately when the price of commodity exports rises, often due to exogenous shocks on both the demand and supply side in the global economy, the Canadian dollar appreciates as net exports increase and Canada becomes a more attractive destination for investment.
It has not always been the case, however, that the exchange rate between the Canadian dollar and the U.S. dollar were closely related to commodity prices. According to the report “Intervention in the Foreign Exchange Market” by the Bank of Canada, before September 1998 the Bank practised a policy of “systematic” intervention in the foreign exchange market to peg the value of the Canadian dollar close to the U.S. dollar. (Bank of Canada, 1) There were periods of time when a rise or fall in the value of the Canadian dollar was not matched with a corresponding change in commodity prices. By using intervention in the foreign exchange market, the Bank tried to keep the value of our dollar close to par with the U.S. dollar. In pursuit of autonomous monetary policy at the expense of a degree of control over the value of the Canadian dollar, the bank has not systematically intervened in the foreign exchange market since before the policy change. (Bank of Canada, 2)
The objective of this paper is not to assign a normative value statement to whether inflation targeting or control over exchange rates is more desirable for an independent central bank. Instead, I aim to demonstrate that exogenous market forces have a stronger impact on the value of an economy’s currency – especially for a large exporter such as Canada. First, I will provide background on relevant literature and topics of interest in relation to my empirical analysis. Next, I will define my formal hypotheses, empirical methodology and data, along with a consideration to improve future research on this topic. Following up, I will demonstrate the results and interpretation of the empirical tests. Finally, I will look at a current monetary policy implication in relation to current commodity prices and the Bank of Canada’s projected overnight rate increase. From the analysis, we will see empirical evidence of a structural difference in the relationship between the USD/CAD exchange rate and commodity prices before and after the foreign exchange intervention policy change made by the Bank of Canada in September 1998.

2. Background

Comparative Risk Assessment Report

Comparative Risk Assessment Report
National Australia Bank Ltd

Contents
Executive Summary
Strategic Risk
Strategic risk analysis – NAB
Comparison of Big Four Banks
Interest Rate Risk
Interest rate risk analysis – NAB
Comparison of Big Four Banks
Market Risk
Market risk analysis – NAB
Comparison of Big Four Banks
Credit Risk and Credit Portfolio Risk
Credit and credit portfolio risk analysis – NAB
Comparison of Big Four Banks
Liquidity Risk
Liquidity risk analysis – NAB
Comparison of Big Four Banks
Foreign Exchange Risk
Foreign exchange risk analysis – NAB
Comparison of Big Four Banks
Conclusion
Appendix:
Reference
Executive Summary This report aims to evaluate existing risks of National Australia Bank including strategic risk, interest rate risk, market risk, credit risk, credit portfolio risk, liquidity risk and foreign exchange risk and make some recommendations to where can be improved by making comparisons with other big three banks in Australia (Commonwealth bank, ANZ and Westpac).
By assessing our Group’s risk profile, it can be concluded that our strategic risk and interest rate risk are almost same as other three banks because of the general economic condition. Our market risk is much lower than any other three banks by using VaR at 99% confidence level, but it does not mean that we have more confidence to avoid this risk, we still need attention and measure our market risk along with other method. The Group’s credit risk is lower than other three banks but still high in terms of financial data which means that we should take actions to try our best to reduce our amount of irredeemable loans. In terms of liquidity risk, our Group experienced the danger of illiquidity in year 2014 which should be paid much attention to liquidity risk. Finally, due to our financial business activities overseas, we are suffering from foreign exchange risk which is same as other three banks.
Last but not least, other risks which include insurance risk, operational risk, compliance risk and reputational risk are not discussed in this report but still need to be noticed.
Strategic Risk Strategic risk analysis – NAB
Strategic risk is the possibility of financial loss arising from changes in the business financial, social or management strategy, both internal and external factors can significantly prevent organizations from achieving their strategic goals. Through our annual report in year 2017, we should recognize that it is possible for our Group to conduct incorrect strategy and we may not react very quickly to cope with such condition. (NAB Annual Report, 2017). Our group has been seeking any opportunity that can improve our financial performance as well as social influence for a long time, however, it may change our Group’s risk profile and capital structure, and inevitably come with reputational and financial risks.
Currently, our Group commits ourselves to climate change events such as reduction of carbon emission, clean energy development, and prioritized through strategic planning processes. The Group participates in the global low carbon transition and it would significantly increase use of renewable energy. However, these strategies will in turn have some effects on our Group’s loan book and investment portfolio (NAB Annual Report, 2017).
Comparison of Big Four Banks
All big four banks are facing strategic risk in terms of implementing new strategic decisions and objectives.
Especially, commonwealth bank states that we are facing severe challenges due to potential adverse impact on climate change and it should be taken into consideration through all material risks. It also takes corporate responsibility programs and activities following some strategic risk as well (Commonwealth bank annual report, 2017).
ANZ manages its strategic risk through their annual strategic planning progresses and any increase in its key risks (credit risk, market risk and operational risk) will be reported and managed by executive committee.
Interest Rate Risk Interest rate risk analysis – NAB
Interest rate risk is the possibility of loss in organizations financial performance caused by fluctuation in interest rate. Organizations may be suffered from loss in earnings and market value due to the result of change in interest rate.
As we can see in the chart 1 below, Australia interest rate has experienced fluctuation during last ten years with a decrease trend in general from 7% to 1.5%. Those changes in interest rate can cause a huge loss to financial institutions as well as banks such as the global financial crisis in year 2008. Besides, such loss due to interest rate mostly caused by the mismatch between the maturity profile of a bank’s lending portfolio compared to its deposit portfolio (NAB annual report, 2017).

Chart 1 – Australia interest rate over last 10 years
By measuring interest rate risk, our Group use techniques include VaR, earnings at risk (EaR), interest rate stress testing, repricing model and cash flow analysis to measure and control interest rate risk in the banking book (IRRBB). The table 1 below shows our Group aggregate VaR and EaR for the IRRBB in year 2016 and 2017.

Table 1
Comparison of Big Four Banks
All four big banks are facing almost same interest rate risk because they are in same economic market and regions.
Commonwealth bank uses two ways to manage and control interest rate risk which includes next 12 months’ earnings and economic value. In terms of the first method, they use repricing model – an asset and liability management simulation model to measure the changes of net interest income over the next 12 months. Interest rate risk from the economic value perspective is measured base on a 20-day 97.5% VaR measure and this measurement is used to evaluate the economic value impact of balance sheet assets and liabilities to negative effect in interest rates.
ANZ and Westpac bank also use almost same ways to measure their interest rate risk including repricing model and maturity model.
Market Risk Market risk analysis – NAB
Market risk is the risk related to the possibility of individual or financial institutions experiencing adverse impact on the profitability or net worth due to factors that affect the overall performance of financial markets which they are involved. This includes changes in interest rate, foreign exchange rates, credit spreads, equity and commodity prices (ANZ annual report, 2017). Market risk is divided by trading market risk and non-trading market risk which the previous one is the potential gains or losses that caused by trading activities conducted by banks result from changes in market prices.
Our Group manages and controls trading market risk by using Value at Risk (VaR) which is a common standard measurement used in bank industry including Commonwealth bank, ANZ and Westpac banks. VaR measures the potential loss that may arise from changes in market features and it is measured at a 99% confidence level. This means that there is a 99% confidence that the loss will not exceed the VaR estimate at any time. (NAB annual report, 2017).

Chart 2
Chart 2 above shows our Group’s VaR during last ten years and it has been experiencing a fluctuation especially during year 2012 to 2015.
Comparison of Big Four Banks
Chart 3 below shows three banks’ VaR during last decades except commonwealth bank because commonwealth bank use VaR at 97.5% confidence level to measure its market risk. As it is shown to us, our Group has relatively low VaR compared to ANZ and Westpac bank especially after the GFC in year 2008. It means that our Group was exposed to much lower risk of potential loss caused by shifts in interest rate, foreign exchange rate, credit spread and more.

Chart 3
However, VaR has its own limitations and disadvantages. It can be misleading in terms of 99% confidence level because 99% confidence level is much far away from 100% in reality world. Moreover, it is difficult to use VaR to calculate with large portfolios (Macroption, 2016). Therefore, we may still need other method to measure market risk.
Credit Risk and Credit Portfolio Risk Credit and credit portfolio risk analysis – NAB
Credit risk is the possible loss from borrowers of banks who cannot repay their debt. Our Group manage credit risk by analysing the ability of existing customers including individual and business organizations regularly to meet the interest and capital repayment obligations. If we find out that they are unable to pay the debt, we will cope with it by changing lending limit.
Credit portfolio risk is the risk of a portfolio of loans as opposed to the risk of a single loan.
Chart 4 below shows our group’s loan asset ratio from year 2011 to 2017 (due to the N.A data from 2006-2011) and it is obvious that this ratio is very high. It means that we are suffering from a big amount of loan and the risk of customers are unable to repay their debt would be also high.

Chart 4
Comparison of Big Four Banks
Chart 5 below shows the big four banks net loan asset ratio, it illustrates that our Group has relatively low net loan asset ratio compared with other three banks although the number is not low at all. It means that big four banks are all exposed to much higher credit risk, if a condition happens that some customers are unable to repay their debt and a large number of customers want to withdraw their money in the bank at the same time, our Group may suffer from the risk of being default.

Chart 5
Liquidity Risk Liquidity risk analysis – NAB
Liquidity risk is the risk that financial institutions are unable to meet their financial obligations as they fall due. Due to external market events, market size or the individual’s behaviour, the liquidity linked to financial markets can be significantly reduced. Our Group’s funding and liquidity risk appetite which is set by the board has responsibility to govern this risk. We use several approaches to manage and control our Group’s liquidity include:
Monitor our Group’s liquidity every day.
Maintain a high-quality liquid asset portfolio.
Operate an economical funding strategy.
Chart 6 below shows the liquid asset ratio which illustrates a fluctuation of this data. Our Group experienced a huge decrease in year 2014 with 7.71% and then increase sharply to 25.12% in 2017. It means that our Group once in danger of liquidity risk in 2014 and then successfully solve it.

Chart 6
Comparison of Big Four Banks
Chart 7 below shows the big four banks liquid asset ratio, obviously, Commonwealth bank was suffering from low liquid asset situation which means that its liquid risk was much higher than other three banks especially during year 2011-2016.

Chart 7
Foreign Exchange Risk Foreign exchange risk analysis – NAB
Foreign exchange risk is the possible loss arises from the effect of change in foreign currency movements in terms of financial institutions’ cash flows, profits and losses. Our Group conduct businesses around the world includes investments in overseas and services to customers, banks and business organizations outside Australia which will in turn bring us not only profits but also risk due to fluctuation of foreign currency exchange rates. Our Group profits will be affected by exchange currency rates and changes in reserve status of these currencies. Negative foreign exchange rates may have an adverse impact on our Group’s financial performance (NAB annual report, 2017).
Comparison of Big Four Banks
Australia big four banks are all exposed to foreign exchange risk as they all have their own financial activities and conduct business overseas.
Conclusion In conclusion, this report evaluates 7 risks of National Australia Bank and compares these risks with other three big banks in Australia. I find out that the average risk level of our Group is lower than other banks, but we still need to pay attention to every risk especially credit risk and liquidity risk which can significantly affect our Group’s performance.
1918 words
Appendix: National Australia Bank Annual Report 2017

Commonwealth Bank Annual Report 2017

Big Four Banks financial ratios

References The Australia and New Zealand Banking Group Limited. (2017). 2017 Annual report. Retrieved from: https://shareholder.anz.com/sites/default/files/2017_anz_annual_report.pdf
Commonwealth Bank of Australia. (2017). 2017 Annual Report. Retrieved from: https://www.commbank.com.au/content/dam/commbank/about-us/shareholders/pdfs/annual-reports/annual_report_2017_14_aug_2017.pdf
Macroption (2016). VAR Limitations and Disadvantages. Retrieved from: https://www.macroption.com/value-at-risk-var-limitations-disadvantages/
National Australia Bank. (2017). 2017 Annual Report. Retrieved from: https://capital.nab.com.au/docs/NAB-2017-annual-financial-report.pdf
TradingEconomics (2017). Australia Interest rate. [online] Trading Economics. Available at: https://tradingeconomics.com/australia/interest-rate
Westpac Group. (2017). 2017 Annual Report. Retrieved from: https://www.westpac.com.au/content/dam/public/wbc/documents/pdf/aw/ic/2017_Westpac_Annual_Report_Web_ready_

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