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Chapter 5 The Nature of Foreign Exchange Risk

Chapter 5 The Nature of Foreign Exchange Risk. 5.1 Exposure to Currency Risk 5.2 The Real Exchange Rate 5.3 The Effect of Changes in Real Exchange Rates 5.4 The Empirical Behavior of Exchange Rates 5.5 Exchange Rate Forecasting 5.6 Summary Appendix 5-A

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Chapter 5 The Nature of Foreign Exchange Risk

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  1. Chapter 5 The Nature of Foreign Exchange Risk 5.1 Exposure to Currency Risk 5.2 The Real Exchange Rate 5.3 The Effect of Changes in Real Exchange Rates 5.4 The Empirical Behavior of Exchange Rates 5.5 Exchange Rate Forecasting 5.6 Summary Appendix 5-A Real Exchange Rates in Continuous Time

  2. A taxonomy of exposures to forex risk • Economic exposure: change in the value of all future cash flows due to unexpected changes in exchange rates • Transaction exposure: change in the value of contractual cash flows • Operating exposure: change in the value of non-contractual cash flows • Translation exposure: changes in financial statements due to unexpected changes in exchange rates (also called accounting exposure) Monetary assets Monetary liabilities Real assets Common equity

  3. A survey of corporate treasurersand financial officers Do you agree or disagree with the following statements? Mean score “Managing transaction exposure is important.” 1.4 “Managing economic exposure is important.” 1.8 “Managing translation exposure is important.” 2.4 Key: 1= strongly agree, ... 3=neutral, ... 5= strongly disagree Source: Kurt Jesswein, Chuck C.Y. Kwok, William R. Folks, Jr., “Adoption of Innovative Products in Currency Risk Management: Effects of Management Orientations and Product Characteristics,” Journal of Applied Corporate Finance, Fall 1995. • Transaction exposure is viewed as the most important currency risk exposure

  4. Change in the nominal exchange rate EXAMPLE S0¥/$ = ¥100/$, E[p¥] = 0%, E[p$] = 10% RPPP Þ E[S1¥/$] = S0¥/$ (1+ p¥)/(1+ p$) = ¥90.91/$ ¥130/$ ¥120/$ ¥110/$ ¥100/$ ¥90/$ ¥80/$ t=0 t=1 • In real (purchasing power) terms, the dollar has appreciated by (¥110/$)/(¥90.91/$)-1 = +.21, or 21 percent more than expected. St¥/$ Actual S1¥/$ = ¥110/$ E[S1¥/$] = ¥90.91/$

  5. The law of one priceand the international cost of living Location Cost Location Cost Tokyo 136.2 New York 94.5 Singapore 109.3 Montreal 69.4 Berlin 74.0 Moscow 93.4 London 101.4 Paris 91.1 Zurich 100.0 Mexico City 62.1 Seoul 96.7 Taipei 86.1 Buenos Aires 72.4 Shanghai 85.5 Hong Kong 95.2 Sydney 79.2 Source: Union Bank of Switzerland, 1997.

  6. The real exchange rate • The real exchange rate adjusts the nominal exchange rate for differential inflation since an arbitrarily defined base period. • Change in the real exchange rate is defined by: 1+xtd/f = (Std/f / St-1d/f) [(1+ptf)/(1+ptd)] where xtd/f = % change in the real exchange rate Std/f = the nominal spot rate at time t ptc = inflation in currency c during period t

  7. Percentage changes in real exchange rates Xtd/f = level of the real exchange rate xtd/f = (Std/f / St-1d/f) [(1+ptf)/(1+ptd)]-1 = [(¥110/$)/(¥100/$)][(1.10)/(1.00)] = 1.21, or a 21% increase 130% 120% 110% 100% 90% 80% t=0 t=1 • Real value of the dollar has appreciated by 21 percent. X1¥/$ = X0¥/$ (1+ x1¥/$) = 1.21 = 121% Xt¥/$ Base: X0¥/$ = 1.00 = 100%

  8. Real value of the dollar(1970-1998) Mean level = 100 for each series

  9. The empirical behaviorof exchange rates Statistical thinking will one day be as necessary for efficient citizenship as the ability to read and write. H.G. Wells

  10. The behavior of nominal exchange rates • Exchange rate changes are approximately normally distributed at each point in time. • At each point in time, exchange rate variance is related to whether the most recent exchange rate changes have been large or small. (That is, variance is autoregressive.)

  11. The behavior of real exchange rates • Deviations from purchasing power parity can be substantial in the short run. • Real exchange rates can take several years to return to equilibrium. • Real exchange rates are autoregressive (that is, they depend on previous levels).

  12. Exchange rate forecasting • Market-Based Exchange Rate Forecasts • E[Std/f] = Ftd/f • E[Std/f] = S0d/f [(1+id)/(1+if)]t • E[Std/f] = S0d/f [(1+pd)/(1+pf)]t • Model-Based Exchange Rate Forecasts • Technical analysis - uses the past history of exchange rates to predict future exchange rates • Fundamental analysis - uses macroeconomic data to predict future exchange rate changes

  13. Continuous time finance(advanced) Recall that std/f = ln(1+std/f) = ln(Std/f/St-1d/f) = ln(Std/f)-ln(St-1d/f) and ptd = ln(1+ ptd) and ptf = ln(1+ ptf) Continuously compounded change in the real exchange rate is xtd/f = ln(1+xtd/f) = ln[(Std/f / St-1d/f ) (1+ ptf )/(1+ ptd)] = ln(Std/f) - ln(St-1d/f) + ln(1+ ptf) - ln(1+ ptd)

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