Chapter 5 The Nature of Foreign Exchange Risk

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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
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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
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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, ... 3neutral, ... 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

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Change in the nominal exchange rate

• EXAMPLE S0/ 100/, Ep 0, Ep 10
• RPPP Þ ES1/ S0/ (1 p)/(1
  p) 90.91/
• 130/
• 120/
• 110/
• 100/
• 90/
• 80/
• t0 t1
• 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/
ES1/ 90.91/
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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.

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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
• 1xtd/f (Std/f / St-1d/f) (1ptf)/(1ptd)
• 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

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Percentage changes in real exchange rates

• Xtd/f level of the real exchange rate
• xtd/f (Std/f / St-1d/f) (1ptf)/(1ptd)-1
• (110/)/(100/)(1.10)/(1.00) 1.21, or
  a 21 increase
• 130
• 120
• 110
• 100
• 90
• 80
• t0 t1
• Real value of the dollar has appreciated by 21
  percent.

X1/ X0/ (1 x1/) 1.21 121
Xt/
Base X0/ 1.00 100
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Real value of the dollar(1970-1998)

• Mean level 100 for each series

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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

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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.)

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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).

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Exchange rate forecasting

• Market-Based Exchange Rate Forecasts
• EStd/f Ftd/f
• EStd/f S0d/f (1id)/(1if)t
• EStd/f S0d/f (1pd)/(1pf)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

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Continuous time finance(advanced)

• Recall that
• std/f ln(1std/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(1xtd/f)
• ln(Std/f / St-1d/f ) (1 ptf )/(1 ptd)
• ln(Std/f) - ln(St-1d/f) ln(1 ptf) - ln(1
  ptd)