Emerging Financial Markets 5: Currency Trading

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Emerging Financial Markets 5 Currency Trading
Risk Management
Prof. J.P. Mei
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How Currency Crisis Happen?

• 1. The "first generation" currency crisis model
  represented by Krugman (1979) and Flood and
  Garber (1984) Strong incentive to engage in
  inconsistent policies during elections by
  pursuing expansionary monetary and fiscal
  policies while holding exchange rates fixed to
  ensure price stability or other policy
  objectives.
• 2. The "second generation" model of Obstfeld
  (1994) Contradicting motives. Jobs and stability
  (Banking problems). In such a model, the cost of
  defending the currency increases when people
  suspect that the government is leaning towards
  abandoning the fixed rate.

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How Currency Crisis Happen?

• 3. There is a possibility that fixed rates may
  be abandoned but not inevitable. Massive exit
  will make this inevitable. Self-fulfilling
  exchange rate crises (see, Hong Kong).
• 4. Heading Behavior You are just one buffalo and
  there are thousands of others!
• 5. Contagion Countries within geographic regions
  are often closely connected both in real and
  financial terms.
• 6. Contingent investment or "real options"
  foreign capital flow to Asia from a huge 93
  billion inflow in 1996 to a 12 billion net
  outflow in 1997.

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Currency Market Movement and Volatility(Notes
for the following table )

• Negative Means reflects devaluation against
  dollar.
• Some markets have low volatility due to currency
  peg. (Volatility could be under-estimated)
• The presence of short-run positive serial
  correlation for most countries.
• Long-term mean reversion (negative serial
  correlation)
• Jumps as a result of government intervention and
  speculative attacks (Thailand).
• Excess skewness and kurtosis may lead to
  under-pricing of derivatives based on
  conventional approach.
• There is cross-correlation and currency market
  contagion in the short-run.

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Currency Statistics
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Currency Market Jumps
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Currency Market Contagion
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Foreign Exchange Risk Exposure at Merck

• Why should the management care?
• It increases the volatility of earnings.
• It make it difficult to maintain a stable
  dividend policy.
• It may scare away Pension fund investors.
• It could impact the firms RD.
• Why it should not care too much in an efficient
  capital market?
• The risk may be diversifiable.
• Systematic risk gets compensated.

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Foreign Exchange Risk Exposure at Merck

• Translation and Transaction exposureChanging the
  dollar value of net asset and expected
  transaction cost
• Future Revenue exposure Changing the dollar
  value of future cash flow
• Competitive Exposure affect labor cost and
  pricing flexibility
• How to measure the exposure from Mercks point of
  view Sales Index
• Index S qj0sjt /(S qj0 sj0 )

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J.P. Mei Approach to FX Risk Management

• Problem Base year may be out of date.
• Identify 20 of the country that contribute over
  80 of the sales. (Narrow down to 8 currencies)
• Use a combination of 1, 2, 3, 4, 5, 6, and 7
  currencies, until you get a combination that
  explain enough variance (good R2) and the
  coefficients are your hedge ratio. (What are the
  most important factors?)
• Salestaa1f1t a2f2t qkfkt et
• Main Weakness
• Ignore Translation exposure
• Ignore Competitive exposure

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• Sales Index Index S qj0sjt /(S qj0 sj0 )
• One need to update the sales index frequently.
• One need to focus on the really important key
  currencies.
• The use of key currencies may take advantage of
  negative correlation as a result of long-short
  position in different countries.
• Choice of hedging instruments Forward or Spot
  (Borrow and sell on the spot, invest the
  proceeds)
• Major determinant credit risk.