Foreign exchange risks
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Foreign Exchange Risks. International Investment. Exchange Risk Exposure. Accounting exposure = (foreign-currency denominated assets) – (foreign-currency denominated liabilities) Transaction exposure : uncertainty in the domestic currency value of the transaction using foreign currency

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Foreign Exchange Risks

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Foreign exchange risks

Foreign Exchange Risks

International Investment


Exchange risk exposure

Exchange Risk Exposure

  • Accounting exposure = (foreign-currency denominated assets) – (foreign-currency denominated liabilities)

  • Transaction exposure: uncertainty in the domestic currency value of the transaction using foreign currency

  • Economic exposure = exposure of the value of the firm (the present value of future cash flows) to changes in exchange rates


How to hedge fx risk

How to hedge FX risk

  • Use forward contracts, futures or options.

  • Use the domestic currency

  • Speed up payments (collections) of currencies expected to appreciate (depreciate)

  • Slow down payments (collections) of currencies expected to depreciate (appreciate)


Fx risk premium

FX Risk Premium

  • The forward rate is equal to the expected future spot rate, or F = Et+1e, if there is no risk premium.

  • If there is a risk premium,

    F = Et+1e + (risk premium)

    The forward rate incorporates a risk premium that induces people to take a risk

  • Is the forward rate an unbiased predictor of future spot rate?


Risk and risk aversion

Risk and Risk Aversion

  • Risk of a given portfolio is measure by the variability of its returns.

  • The more variable the return, the less certain about its value.

  • Risk Aversion: the tendency of investors to avoid risk

  • FX risk premium = (F - Et+1e)/Et


Fx risk premium1

FX Risk Premium

  • Look at CIP again

    ius – iJ = (F - Et)/Et

  • But

    (F – Et)/Et = [(F – Et+1e) + (Et+1e - Et)]/Et

  • So

    ius – iJ = (Et+1e - Et)/Et + (Risk premium %)


Fx risk premium2

FX Risk Premium

  • If this FX risk premium = 0, then

    ius – iJ = (Et+1e - Et)/Et

    Uncovered Interest Parity (UIP)

  • “The forward rate is an unbiased predictor of the future spot rate”  F = Et+1e

     FX risk premium =0.


Example

Example

  • The dollar-yen spot and 6-month forward exchange rates E$/¥ on Friday 3/22/02 are

    Et = .007530 ¥132.80/$

    Et+1e = .007587¥131.80/$

    F = .007617 ¥131.29/$

  • Then

    FX risk premium  (F- Et+1e)/ Et = 0.00398

    Expected appreciation of the Yen  (Et+1e-Et)/ Et

    = 0.00757

    Forward premium  (F- Et)/ Et = 0.01155


Example cont d

Example (cont’d)

  • The 6-month Eurodollar and Euroyen rates are 2.31% and 0%:

    ius = 0.01155 and iJ= 0

    So ius – iJ = 0.01155

  • The expected return from holding a Japanese bond is

    iJ + (Et+1e - Et)/ Et = 0.00757 < ius = 0.01155


Market efficiency

Market Efficiency

  • Prices reflect all available information  Efficient Market

  • The Fed unexpectedly lowers the interest rate.  An immediate decline of the dollar or Et

  • In an efficient market,

    F - Et+1e = FX risk premium.


Market efficiency cont d

Market Efficiency (cont’d)

  • Suppose F > Et+1e + FX risk premium.

    An investor would get profits by selling forward currency now (short position in the Euro) and buying it back later.

  • If F < Et+1e + risk premium, an investor should buy forward currency now (long position in the Euro) and sell it later.


Test for market efficiency

Test for Market Efficiency

  • Statistical tests for the efficiency of the FX market

  • Is there any other variables in addition to the forward rate (F) that can help predict the future spot rate (Et+1e)?

  • If no, then the forward rate contains all relevant information about the future spot rate.


Foreign exchange forecasting

Foreign Exchange Forecasting

  • There is some evidence that the forward rate is not an unbiased predictor of the future spot rate.

  • But conflicting evidence on the ability of exchange rate forecasting to forecast better than the forward rate.


International investment

International Investment

  • Differences in the returns on assets in different countries

  • Diversified portfolio provides lower risk with the same expected return.


International investment cont d

International Investment (cont’d)

  • Systematic risk: The risk common to all investment opportunities. Related to Business cycles.

  • Non-systematic risk: The risk that can be eliminated by diversification.


International investment cont d1

International Investment (cont’d)

  • Direct Foreign Investment (DFI or FDI): actual establishment of a foreign operating unit

  • Portfolio Investment: purchase of foreign securities


International investment cont d2

International Investment (cont’d)

  • Late 1970s: “Recycling” of the oil money International bank lending 

  • mid 1980s: Debt crises and non-repayment  Bank lending 

  • Early 1990s: “Emerging market” boom  portfolio investment 

    Mexico currency crisis (1994)  “Tequila effect” portfolio investment 

  • Late 1990s: DFI 


Portfolio investment and dfi

Portfolio investment and DFI

  • Portfolio investment

    Short-term motives  contributes to a financial crisis

    used for consumption spending

  • Direct foreign investment

    Long-term commitment

    used for productive investment

    involves technological transfer


Capital flight

Capital Flight

  • Risk  or expected return  massive outflows of investment funds; KA 

  • Caused by:

    Political or financial crisis

    Capital controls

    Tax increases

    Devaluation fear


Capital inflows

Capital Inflows

  • Early 1990s: Capital inflows to developing countries (FDI as well as portfolio investment) 

  • Benefits: Capital inflows help the countries finance, for example, domestic infrastructure.


Potential problems with capital inflows

Potential Problems with Capital Inflows

  • A sudden capital inflow an appreciation of the domestic currency

     export 

     output 

     unemployment 

  • A sudden capital inflow  KA  & CA  (why?)

  • A sudden capital inflow  FX intervention

     money supply 

     inflation


Policy responses

Policy responses

  • Fiscal restraint: cut gov’t spending and raise taxes (contractionary fiscal policy)

  • Exchange rate policy

  • Capital controls: taxes and quotas in capital flows; raise reserve requirements; restriction on FX transactions.


International lending and crisis

International Lending and Crisis

  • 1980s: Debt crises in Latin American countries

  • 1994-95: Mexican financial crisis—Mexico devalued the peso; a large loan from the IMF and the US treasury

  • 1997-98: Asian financial crises—devaluation in Thailand  financial panics spread to Malaysia, Indonesia, the Philippines and South Korea.


International lending and crisis1

International Lending and Crisis

  • After crises, bank lending 

  • The exposure of international banks in the 1997 Asian financial crises is much smaller than in Latin American debt crises in 1980s.


Asian financial crisis

Asian Financial Crisis

  • Twin crisis: Currency crisis + Bank crisis

  • Currency crisis:

    fear of devaluation  investors flee

    a currency

     

    pressure for  capital flight

    a devaluation


Causes of asian financial crises

Causes of Asian financial crises

  • External shocks: depreciation of Yen and renminbi

  • Macroeconomic policy: Fixed exchange rates

  • Financial system flaws:

    “Crony capitalism”

    Moral Hazard


Defense of fixed rate and crisis

Defense of Fixed rate and Crisis

  • Pressure for a devaluation (e.g. CA)

  •  defend the fixed rate (FX intervention, raise interest rate, capital controls)

  •  Speculative attack

  •  abandon the fixed rate—devaluation

  •  (foreign currency denominated) debt 


Financial system flaws

Financial system flaws

  • A banking system based excessively on directed lending, connected lending, and other collusive personal relations. “Crony capitalism”

  • Bank bailout guarantee by the gov’t

     banks take excessive risk (Moral hazard)


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