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
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
The forward rate is equal to the expected future spot rate, or F = Et+1
e , 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 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 Premium
Look at CIP again
ius – iJ = (F - Et)/Et
But
(F – Et)/Et = [(F – Et+1e) + (Et+1
e - Et)]/Et
So
ius – iJ = (Et+1e - Et)/Et + (Risk premium %)
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.
Example
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)
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
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)
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
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+1
e)? If no, then the forward rate contains all
relevant information about the future spot rate.
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
Differences in the returns on assets in different countries
Diversified portfolio provides lower risk with the same expected return.
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’d)
Direct Foreign Investment (DFI or FDI): actual establishment of a foreign operating unit
Portfolio Investment: purchase of foreign securities
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
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
Risk or expected return massive outflows of investment funds; KA
Caused by:
Political or financial crisis
Capital controls
Tax increases
Devaluation fear
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
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
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
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 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
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
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
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