Forex%20Exposure%20and%20Risk

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Forex Exposure and Risk

• International Corporate Finance
• P.V. Viswanath

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Learning Objectives

• What is foreign exchange exposure?
• What is foreign exchange risk?
• How do we measure foreign exchange risk and
  foreign exchange exposure?
• What factors contribute to risk and exposure?

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Foreign Exchange Exposure

• Foreign Exchange exposure is the sensitivity of
  real US-dollar values of assets or liabilities
  with respect to unanticipated changes in exchange
  rates.
• Foreign exchange exposure ?V/?e
• How the value of an asset/liab changes for a unit
  change in the exchange rate.
• Suppose, we use the euro as the foreign currency.
• Then, since the denominator is measured in /,
  and the numerator is measured in , exposure,
  therefore, is measured in terms of the foreign
  currency.

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Forex Exposure on Assets/Liabs

• Contractual assets or liabilities are those with
  domestic-currency values
• Exposure on a contractual asset or liability
  equals the value of the asset or the liability.
• Suppose there is a bank deposit of 1,000.
• Suppose, again, that the exchange rate moves from
  1.2572/ to 1.2577/. Then the value of the
  bank deposit will change from 1257.2
  (1,000x1.2572) to 1257.7 (1000x1.2577).
• Hence the amount of the exposure works out to
  (1257.2-1257.7)/(1.2572-1.2577) 1,000.

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Exposure for Contractual Assets/Liabs

• The positive sign indicates that an increase in
  the exchange rate (appreciation of the foreign
  currency) causes a increase in the dollar value
  of the asset.
• Hence we say that the asset represents a long
  euro position.
• Long foreign exchange exposure is when an
  investor gains when the foreign currency rises
  and loses when the foreign currency declines.
  Short exposure is when the opposite happens.

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Exposure on a non-contractual asset

• Suppose a US investor holds shares in PPR S.A.
  (formerly known as Pinault-Printemps-Redoute)
  shares, traded in France. The current price
  (June 19, 2006) of the stock is 97.75, which
  works out to 122.89 at the current exchange rate
  is 1.2572/.
• The group owns brand names such as Gucci, YSL and
  Boucheron. According to Yahoo, 12 of its sales
  are in the US.
• Suppose the exchange rate rises to 1.2577/.
  Since PPRs products would cost more in the US,
  its US sales would drop and hence the stock
  price might suffer.
• Suppose the price is expected to drop to 97.65,
  or 122.81 (97.65x 1.2577).
• Then, the exposure would be (122.81-122.89)/(1.257
  7-1.2572) or -160

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Exposure on a non-contractual asset/liab

• Exposure on a foreign asset or liability can be
  higher or lower depending on the correlation
  between the local-currency value of the
  asset/liability and the exchange rate.
• Exposure can be higher than the foreign-currency
  value if the local-currency asset price and the
  exchange rate move in the same direction.
• This can happen with investments in foreign
  import-oriented companies that become more
  profitable when the importers domestic currency
  appreciates, and less profitable when the
  importers currency depreciates.
• The reverse is also possible with investments in
  foreign export-oriented companies that become
  more profitable when the domestic currency falls.

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Forex exposure in bonds

• An investor in foreign-currency bonds is exposed
  by more than the value of the bonds if the
  foreign central bank leans against the wind.
• This means that the central bank raises interest
  rates when the home currency depreciates and
  vice-versa.
• Domestic currency-denominated bonds can be
  exposed to exchange rates if the home country
  central bank leans against the wind. If interest
  rates affect stock prices, the domestic stock
  market as a whole is also exposed.

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Measuring forex exposure

• Exposure can be measured by the slope coefficient
  in a regression equation relating the real change
  in the dollar value of assets/liabilities to
  changes in exchange rates.
• For exposure to exist, dollar values must on
  average change in a particular way vis-à-vis
  unanticipated change in exchange rates.
• When exposures exist against several currencies,
  they can be measured from the slope coefficients
  in a multiple regression.

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Euro exposure of an investor in DCX

• I recorded the daily share price of
  Daimler-Chrysler from June 16, 2003 to July 1,
  2004 (Yahoo) and computed the daily return.
• I then took the change in the exchange rate and
  regressed the former (DCX return) against the
  change in the exchange rate, and obtained
• RDCX 0.000162 0.01912 (?e)
• N 217, R2 0.002, t-stat for slope -0.628
• No evident exposure
• How do we interpret this? 52 of DCXs sales are
  in the US and 33 in Europe (Yahoo).

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Forex Risk

• Forex risk is measured by the standard deviation
  of domestic-currency values of assets or
  liabilities attributable to unanticipated changes
  in exchange rates.
• It can be computed as ?.?(?eu)
• If the foreign currency is the , ? is measured
  in , eu and hence ?(?eu) are measured in /
  hence risk is measured in units of volatility.
• In our case, ?(?eu) 0.016219 hence ?.?(?eu)
  (0.01912)(0.016219)365 11.32 per year.
• Keep in mind, however, that the t-statistic is
  much below 2.0

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Forex Risk and IRP

• Foreign exchange risk is positively related to
  both exposure and the standard deviation of
  unanticipated changes in exchange rates.
• When a foreign currency-denominated security is
  not hedged with a forward exchange contract, it
  is exposed, irrespective of whether interest rate
  parity holds.
• If IRP holds, a 1 investment in the euro,
  appropriately hedged, will generate
  (f1/e0)(1r) if IRP holds, this will equal
  (1r). There is no exposure, due to the
  hedging.
• However, if we have not hedged our exposure, then
  there will be exposure, whether or not IRP holds,
  equal to (1/e0)(1r) and forex risk equal to
  (1/e0)(1r).?(?eu).

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Forex Risk and PPP

• On the other hand, if PPP holds, there will be no
  exposure.
• This is because, according to PPP, P e.P
• If exchange rates change, foreign prices are
  going to adjust so that domestic values do not
  change.
• If individual asset values do not always change
  by the overall rate of inflation for a country
  but on average change at the rate of inflation,
  exposure is zero if PPP holds on average.
• With random departures from PPP, there is an
  added source of risk but this is part of the
  total risk, not the foreign exchange risk.

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Operating Exposure

• The sensitivity of operating income to changes in
  exchange rates is called operating exposure and
  the standard deviation of operating income due to
  unanticipated changes in exchange risk is called
  operating risk.
• If PPP always holds exactly and market prices and
  production costs always move in line with overall
  inflation, there is no operating exposure or
  operating risk. If PPP holds only on average and
  prices and production costs move on average at
  the overall rate of inflation, there is still no
  exchange rate exposure or risk, but there is
  greater total risk.

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Operating Exposure and PPP

• Consider a UK firm exporting to the US. His
  profits in equal ? (ep-c).q
• Suppose the exchange rate changes. Then,
  assuming that there is no impact on q, we have
• ??/?e qpe?p/?e
• If PPP holds, then ?p/?e -p/e2. Substituting
  above, we see that ??/?e qp-p/e 0.
• Hence if PPP holds, then there is no operating
  exposure.
• If, however, an individual companys prices and
  costs do not change at overall inflation rates,
  then there will be operating exposure, even if
  there are no overall deviations from PPP.