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
F = Et+1e + (risk premium)
The forward rate incorporates a risk premium that induces people to take a risk
ius – iJ = (F - Et)/Et
(F – Et)/Et = [(F – Et+1e) + (Et+1e - Et)]/Et
ius – iJ = (Et+1e - Et)/Et + (Risk premium %)
ius – iJ = (Et+1e - Et)/Et
Uncovered Interest Parity (UIP)
FX risk premium =0.
Et = .007530 ¥132.80/$
Et+1e = .007587¥131.80/$
F = .007617 ¥131.29/$
FX risk premium (F- Et+1e)/ Et = 0.00398
Expected appreciation of the Yen (Et+1e-Et)/ Et
Forward premium (F- Et)/ Et = 0.01155
ius = 0.01155 and iJ= 0
So ius – iJ = 0.01155
iJ + (Et+1e - Et)/ Et = 0.00757 < ius = 0.01155
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.
Mexico currency crisis (1994) “Tequila effect” portfolio investment
Short-term motives contributes to a financial crisis
used for consumption spending
used for productive investment
involves technological transfer
Political or financial crisis
fear of devaluation investors flee
pressure for capital flight
banks take excessive risk (Moral hazard)