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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

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.

  • 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)