Foreign Exchange Exposure and Risk by alicejenny

VIEWS: 7 PAGES: 23

									                                   Chapter 12
                    Foreign Exchange Exposure and Risk


The Nature of Exchange-Rate Risk and Exposure
         Definition of Foreign Exchange Exposure
         Exposure as a Regression Slope
         Estimating Exposure
         Units of Measurement of Exposure
         Exposure When Local-Currency Values Vary with Unanticipated
         Changes in Exchange Rates
         Exposure against Numerous Exchange Rates
         Exposure on “Domestic” Assets, Liabilities, and Operating Incomes
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         Estimation Difficulties
         Definition of Foreign Exchange Risk
Exposure, Risk, and the Parity Relationships
         Exposure, Risk, and Interest Parity
         Exposure, Risk, and Purchasing-Power Parity




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The Nature of Exchange-Rate Risk and Exposure - Definition of Foreign
Exchange Exposure
1. To clarifying the nature and measurement of risk and exposure
         To explaining the factors contributing to them
         To managing the risk and exposure
2. Definition: Foreign exchange exposure is the sensitivity of changes in the real
         domestic-currency value of assets, liabilities, or operating incomes to
         unanticipated changes in exchange rates.
         (1)sensitivity:the extent or degree to which the home-currency value of
              something is changed by exchange rate changes
         (2)real domestic-currency value:inflation-adjusted
         (3)assets, liabilities, and operating incomes:exposure exists on stocks and
              flows
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             ◎ Stocks—so much in a particular moment in time:the values of assets
                  and liabilities
             ◎ Flows—so much per period of time:the values of incomes
         (4)unanticipated changes in exchange rates can affect both domestic and
             foreign exposed items
         (5)unanticipated changes




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Exposure as a Regression Slope
1. Figure 12.1.    Exposure as the Slope of a Regression Line
         (1)Two axes.

             ◎ Horizontal axis:unexpected changes in exchange rates, SU($/£)
             ◎ Vertical axis:the changes in the real values of assets, liabilities, and

                  operating incomes in terms of a reference currency, V($)
         (2)A systematic relationship
             The dollar value of a foreign-currency item is influenced by exchange rates
             among other factors. There is a tendency for values to change in more or
             less predictable ways. When there is such a tendency we say that there is
             a systematic relationship between the dollar value of the item and the
             exchange rate.

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         (3)An example:When the pound unexpectedly jumps from $1.50/£ to $
             1.70/£, the U.S. dollar value of a £1 million bank deposit changes from
             $1.5 million to $1.7 million, and this change in dollar value can be
             accurately known.
             ◎ Point A in Figure 12.1.(a):SU($/£) = $0.2/£ and V = $
                  200,000
         (4)With the pound value of the bank deposit unchanged by changes in
             exchange rates, all points sit exactly on the exposure line, which for the
             bank deposit is upward-sloping.
2. Extensions
         (1)the pound value of British items might change, but not always in the same
             way, as the same time as the exchange rate changes

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         (2)domestic assets, liabilities, and operating incomes may also change with
              changes in exchange rates
3. Regression equation
         (1)The form
              (12.1)         V =  SU($/£) + 
              ◎ Systematic relationship:SU and V are on average related to each
                  other
              ◎ Regression coefficient: describes the tendency for SU and V to be
                  related
              ◎ Regression error: is the random error in the relationship
         (2) is the sensitivity measure we have called foreign exchange exposure.
         (3)Redefine exposure:Foreign exchange exposure is the slope of the
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         regression equation which relates changes in the real domestic currency
         value of asset, liabilities, and operating incomes to unanticipated changes in
         exchange rates.




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Estimating Exposure
1. Observations of SU and V
            
         (1) SU:forward exchange rates, which are predictions of future spot exchange
              rates, and subtracting the forward rates from the actual exchange rates
             :
         (2) V dollar values of assets and liabilities may be apparent in stock and bond
              prices
2. The exact exposure line versus the scatters
         When there is noise in the relationship between the unanticipated changes in
         exchange rates and changes in the dollar values, we must use statistical
         procedures to fit the line and find the systematic relationship through the scatter
         of points.
3. The estimate of exposure is the estimated value of .

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Units of Measurement of Exposure
1. If V is measured in U.S. dollars, as it will be if we are measuring exposure from a
          U.S. perspective, and if SU is measured in dollars per pound, then exposure,
          that is, , must be measured in pounds.
2. An example
          (1)In equation(12.1), assuming  = 0

               $200,000 =  × $0.2/£
               Thus,  = £1,000,000.
          (2)We find that exposure is £1 million.         This is the amount that is at risk to
               unanticipated changes in exchange rates.
          (3)Long exposure:when the slope is positive; short exposure:when the slope
               is negative

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Exposure When Local-Currency Values Vary with Unanticipated Changes in
Exchange Rates
1. An example
          (1)Before British inflation:the British value of a piece of British real estate is
               £1 million and the exchange rate is $1.8/£
               The dollar value of the real estate is
                   $1.80/£ × £1 million = $1.8 million
          (2)                       :
             After British inflation the British value of the real estate is £1.125 million
               and the exchange rate is $1.6/£
               The dollar value of the real estate is
                   $1.60/£ × £1.125 million = $1.8 million
          (3)In equation(12.1), assuming all change in exchange rate is unanticipated,

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              then
                     SU = -$0.2/£ and V = 0, so that
                     (12.2)        0 = (-$0.2/£) + 

                     If  is zero, then the only way equation (12.2) can hold is if  = 0.
                     That is, if the pound value of the British real estate and the exchange
                     rate of the pound change systematically as in the example, the real
                     estate is not exposed.
2. Other examples
          (1)On selecting different numbers we would have found the real estate to be
              exposed to unanticipated changes in exchange rates
          (2)Examples on page 299



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Exposure against Numerous Exchange Rates
1. When many different exchange rates can affect V, as when V is the value of a
          firm that holds assets and liabilities in many countries and currencies or earns
          incomes in many countries and currencies, we can use an extension of equation
          (12.1) to estimate exposure.
          (1)The multiple regression equation

               (12.3)           V = 1SU($/£) + 2SU($/DM) + 3SU($/¥) +
                                4SU($/SFr) + 
               If V could be influenced by the exchange rates of the dollar versus the
               British pound, German mark, Japanese yen, French franc, and so on.
          (2)Each slope coefficient gives exposure to the associated foreign currency.
               ◎ For example:2 gives the sensitivity of V to unanticipated changes in

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               the U.S. dollar value of the German mark.
          (3)The coefficients are all measured in units of the foreign currency.
2. Summary:Exposure to an individual currency is the sensitivity of the real
          home-currency value of an asset, liability, or operating income to unanticipated
          changes in the foreign exchange value of that currency, assuming unanticipated
          changes in all other exchange rates are zero.




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Exposure on “Domestic” Assets, Liabilities, and Operating Incomes
1. A U.S. perspective
          The U.S. dollar values of U.S. assets may be systematically affected by
          exchange rates, that is, these items may well be exposed to exchange rates.
          (1)For example:the case of U.S. bonds
                         The U.S. dollar falls against other currencies
                                                
                    The Fed adopts a policy called leaning against the wind
                                                
          The Fed tries to reduce the dollar’s depreciation by increasing interest rates
                                                
                           The market values of U.S. bonds decline
               ◎ If the relationship between exchange rates and interest rates is
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                  systematic, the U.S. holders of U.S. bonds are exposed to exchange
                  rates.
              ◎ There is a negative association between SU($/£) and V.
          (2)For example:the case of U.S. stocks
              If U.S. stock prices systematically decline as U.S. interest rates increase,
              then the Federal Reserve’s policy of leaning against the wind will expose
              U.S. stocks.
              ◎ While stock prices in general might decline when the U.S. dollar
              unexpectedly depreciates, some stocks may benefit from the dollar
              depreciation.
              ◎ U.S. export-oriental and import-competing firms



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Estimation Difficulties
The calculation of exposure is not easy, because exposure changes over time. We
might need an analysis of possible scenarios. This involves the generation of values
of V which might occur for different SU’s.




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Definition of Foreign Exchange Risk
1. Adler and Dumas’s definition:They define foreign exchange risk in terms of the
          variance of unanticipated changes in exchange rates, that is, var(SU).
2. The author’s definition:Foreign exchange risk is measured by the variance of the
          domestic-currency value of an asset, liability, or operating income that is
          attributable to unanticipated changes in exchange rates.
          (1)Exchange–rate risk depends on exposure as well as on var(SU).

                               V  V + 
                                       ^
          (2)(12.5)
               ◎ We have partitioned the total change in value, V, into that due to
                    changes in exchange rates, V , and that due to other influences, .
                                                  ^




               ◎ We define the variable V = SU($/£), that is, the change in value
                                             ^




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              of an asset, liability, or operating income that is due to unanticipated
              changes in the exchange rate.
          ◎ The author’s definition of exchange rate risk is var(V ).
                                                                     ^




                            var(V ) = 2var(SU)
                                   ^
              (12.6)
              Exchange–rate risk depends on exposure as well as on var(SU).




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Exposure, Risk, and the Parity Relationships - Exposure, Risk, and Interest
Parity
1. Covered Interest Parity
          (1) Equation (11.10)
               The RHS of equation (11.10) gives the hedged dollar receipts to an investor
               on a covered n-year British pound interest-bearing security.
               ◎ If the pound security is hedged (by a forward contract) and held to
               maturity, unanticipated changes in exchange rates can have no effect on the
               dollar value of the security. That is, the hedged pound security is not
               exposed and faces no foreign exchange risk.
               ◎ When a foreign-currency-denominated security is not hedged with a
               forward contract or may be sold before maturity, the security is exposed
               and subject to exchange-rate risk.
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          (2) Implication of interest parity
               While interest parity dose suggest that anticipated changes in exchange
               rates are compensated for in interest differentials, there is no compensation
               for unanticipated changes in exchange rates. With NO implication of
               interest parity for a systematic effect of SU($/£) on the value of
               pound-denominated interest-bearing securities, there is NO implication for
               exposure and exchange-rate risk.




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Exposure, Risk, and Purchasing-Power Parity – PPP and Real-Asset Exposure
1. Table 12.1. PPP and Real-Asset Values
          (1) These numbers imply that the dollar value of the real estate is unchanged and
               equal to $1.8 million despite the change in exchange rate. If this
               situation systematically occurred the real-estate investment would not be
               exposed (causing an exposure of zero).
          (2) Why?
               ◎ If British real-estate prices followed the overall British rate of inflation
               ◎ If the relative form of PPP holds, S-dot could be calculated
               ◎ From S at time 0 and S-dot, the S at time 1 cold be calculated
          (3) Summary
               If PPP held precisely in an ex post sense, and if the pound value of the

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          British real estate precisely followed the British rate of inflation. In such
          a situation there is zero exposure and also no foreign exchange risk.




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