Empirical study

The uncovered interest rate parity holds if the spot rate at maturity is expected to match the forward exchange rate. The EUR/HUF and CHF/HUF market development is demonstrated by Figures 4 and 5 from 2001, the date of the liberalization of the forint.

14 KIRÁLY and SIMONOVITS, 2017

Figure 4: The EUR/HUF spot rate and the lagged one year forward rate between 2002−2018 (left axis) and the difference of the two (right axis)

Source: Bloomberg

Figure 5: The CHF/HUF spot rate and the lagged one year forward rate between 2002−2018 (left axis) and the difference of the two (right axis)

Source: Bloomberg

The dark line shows the spot rate, and the light one shows the one year forward rate one year before, i.e. the exchange rate of the just maturing transactions. In case the uncovered interest rate parity holds, the size of the grey areas that show the difference of the two, under and above the zero axis, should be equal.

It can be seenin both figures that, until 2008, the positive difference is denominated, and the forward exchange rate for the majority of the period exceeded the spot rate at maturity.

During this period, there were some periods when the one-year foreign exchange loan proved to be more expensive than the HUF loan. In a longer credit construction, however, the foreign exchange loan debtors were obviously better off.

After 2008, the foreign currency rate that was considered stable before substantially weakened as a consequence of which the payment obligations of the foreign currency loans rose over the burdens of the HUF loan.

I will investigate two questions below. On one hand, I will examine how a rational credit borrower in the summer of 2008, directly before the crisis, considered the risks of EUR and CHF loans. On the other hand, I will analyse how much more expensive a 10-year foreign currency loans taken out in 2008 was for the credit borrower as compared to an HUF loan.

Although in 2015, the retail foreign currency credits were converted into forints, nearly half of the corporate loans are still foreign denominated (see Figure 1).

2. 1. Risk of Foreign denominated loans as of 2008

According to the efficient market hypothesis,¹⁵ the prices of products traded on the financial markets reflect all available information; therefore, their change is due to random, new incoming information. Hence, the price movement has Markov nature and the geometric Brownian motion (GBM) is used for describing the price development.

Presuming the development of the foreign exchange rate according to the GBM, the annual logarithmic return is a normally distributed random variable, the parameters of which can be estimated from the returns of the previous periods as a random sample from the underlying distribution.

In case an investor had modelled the exchange rates at the end of August 2008, based on the EUR/HUF and CHF/HUF prices of the previous five years, one could observe that the HUF was expected to strengthen against the EUR by 1.3% annually and against the CHF by 2.26%

annually. Moreover, the exchange rate volatility would have been 8–9% on an annual level. The one- and ten-year foreign interest rates were 3–5% lower on an annual basis than the HUF rates.¹⁶ Based on the model, therefore, the credit borrower could expect that despite the substantial inte-rest rate difference, not only would the HUF not weaken according to the uncovered inteinte-rest rate parity but also would strengthen, making the foreign exchange loan even cheaper.

The Markowitz portfolio theory (1952) presumes that an individual decision-maker’s utility function depends on the expected return (E(r)) and its variance (ơ²) .

(6)

Where, is the risk aversion coefficient, which measures how sensitive the investor is towards the risk measured by the variance. Calculating the level of risk aversion above which the decision-maker would rather choose the expectedly more expensive but risk-free credit borrowing alternative, the received values are 13.82 and 18.80. As a comparison, the long-term average risk premium of the American equity market (approx. 8%) with 20% volatility corresponds to a 3.6 risk aversion coefficient.

15 MALKIEL and FAMA, 1970

16 Based on the yields of government bonds.

The data is summarized in Table 2.

Exchange rate (Compared

to the HUF) Interest rate difference

(Compared to the HUF) Rate of risk rejection

Drift Volatility 1-year 10-year A

EUR −1.30% 8.12% 3.12% 3.25% 13.82

CHF −2.26% 8.64% 5.26% 4.75% 18.80

Table 2: Exchange rate modelling based on market data at the end of August 2008 Source: Bloomberg, ÁKK, ECB, SNB

The analysis assumes that the returns are stationary, i.e. the parameters of the underlying distribution are stable.

2. 2. The cost of foreign exchange loan between 2008 and 2018

The crisis led to a structural change in the financial markets, and the model parameters changed substantially. Regarding the EUR/HUF exchange rate relation, based on the figures of the ten years between 2008 and 2018, the rate of growth for the exchange rate increased to 3.5% per year.

It was only slightly higher than the difference of the 10-year interest rate levels in 2008.

Figure 6: The EUR/HUF spot rate and the forward rate fixed in August 2008 (left axis) and the difference of the two (right axis)

Source: Bloomberg

In Figure 6, the light line indicates the forward exchange rates that could have been fixed at the end of August 2008, while the dark line indicates the actual spot rates. The grey area is the deviation from the uncovered interest rate parity. Compared to Figure 4 that indicated the difference from uncovered interest rate parity for one year, Figure 6 compares the spot rate movement and the forward rate fixed in August 2008 for the given day. In case of a 10-year loan, the actual cost was determined by the repayment schedule. If we examine an

annuity construction, the costs of EUR loans taken in August 2008 exceeded the costs of the HUF loan by one percentage point.

This raises a question: if with the worst scheduling – with credit taken out by the lowest foreign currency rate followed by a continuous exchange rate increase – the foreign exchange loan only proved to be one percentage point more expensive than the HUF loan, why do so many people talk about a national catastrophe occurring?

By 2008, the majority of the retail foreign exchange loans were in Swiss francs denominated.

17 The exchange rate of the Swiss franc, as compared to the HUF, went through an even more drastic change. Figure 7 shows that the debt in Swiss francs had a considerable exchange rate loss throughout the entire period.

Figure 7: The CHF/HUF spot rate and the forward rate fixed in August 2008 (left axis) and the difference of the two (right axis)

Source: Bloomberg

The annual growth rate of the Swiss franc exchange rate between 2008 and 2018 was about 7.5%. To pay the monthly instalments for ten years of a loan taken out in 2008, the CHF had to be purchased at an average 39% higher foreign exchange rate than what the forward exchange rate was in 2008. Therefore, the interest rate of a 10-year annuity payment CHF credit exceeded the interest rate of a similar HUF loan by total 7.74 percentage points ex-post.