FOREIGN EXCHANGE EXPOSURE AND RISK

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FOREIGN EXCHANGE EXPOSURE AND RISK

• FX-market participants are interested in
  estimating their FX exposure and FX risk
• FX exposure is the sensitivity of changes in the
  real domestic-currency value of assets,
  liabilities or operating incomes to unanticipated
  changes in exchange rates

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• Notice that
• ? exposure is the degree to which the
  home-currency value of something is changed by
  exchange rate changes
• ? exposure deals with the real domestic-currency
  values, meaning that values are adjusted for
  inflation

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• ? FX exposure can affect assets and liabilities,
  which are stocks, as well as operating incomes,
  which are flows
• ? The definition does not refer to foreign items
  only FX exposure also can affect the values of
  domestic items

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• ? The definition refers to unanticipated changes
  in exchange rates because anticipated changes can
  be compensated for through the market
• We can obtain an estimate of FX exposure by
  regressing the change in the real
  domestic-currency value on unanticipated changes
  in the exchange rate

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EXAMPLE OF ESTIMATING FX EXPOSURE

• Consider a 1m deposit in a U.S. bank. Assuming
  that values are in real terms (ignore inflation
  levels and rates), what is the effect of
  unanticipated changes in the DM/ rate?
• Changes in real values are measured in terms of a
  reference currency (in our example, assume the DM)

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• Suppose the DM/ rate changes from DM1.5/ to
  DM1.7/
• DM-value of the deposit increases by DM200,000
• We can plot the change in DM value against the
  unanticipated change in the DM/ rate
• We can do the same for unanticipated appreciation
  of the DM against the

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• Plotting all possible combinations, we derive the
  exposure line
• Exposure line has a positive slope for assets and
  a negative slope for liabilities
• Thus, FX exposure can be estimated from
• ?V ??Su(DM/) ? (1)

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IN WHAT CURRENCY IS FX EXPOSURE MEASURED?

• Consider our example
• ? reference currency is DM
• ? change in real value of deposit is measured in
  DM
• ? unanticipated change in exchange rate is
  measured in DM/
• ? FX exposure is measured in

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• This is because
• ? DM ? (DM/)
• ? ? DM ? (DM/)
• In the above example
• ? DM 200,000 ? (DM 0.20/)
• ? ? DM 200,000 ? (DM 0.20/) 1 million

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• Interpretation this is the amount that is at
  risk to unanticipated changes in the exchange
  rate
• If the 1m is a loan, then the unanticipated
  change in the exchange rate would result in a
  loss of DM200,000
• In this case, ? - 1 million

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• If the estimated coefficient is negative, we say
  that we have a short exposure
• If the estimated coefficient is positive, we say
  that we have a long exposure

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WHAT IF LOCAL-CURRENCY VALUES CHANGE WITH
UNANTICIPATED CHANGES IN EXCHANGE RATES?

• Suppose that an economy experiences inflation,
  which also depreciates its currency
• How do these changes affect FX exposure?
• Consider the following example. Suppose that we
  own a house in the U.K. with market value 1m
  when the exchange rate is 1.8/
• Due to rising inflation, the exchange rate moves
  to 1.6/ and the market value to 1.125m

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• In this case, the value of the property has not
  changed
• FX exposure is zero
• British real estate is not exposed because change
  in exchange rate counterbalances change in pound
  value

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FX EXPOSURE ON DOMESTIC ITEMS

• Domestic assets, liabilities or operating incomes
  may also be exposed to unanticipated changes in
  exchange rates
• E.g. The Central Bank raises interest rates to
  support the value of the domestic currency
• This will affect the values of domestic stocks,
  bonds, and operating incomes

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FX RISK

• FX risk is measured by the variance of the
  domestic-currency value of an asset, liability or
  operating income that is attributable to
  unanticipated changes in exchange rates
• Notice that
• ? FX risk refers to unpredictability of values
  due to unanticipated changes in exchange rates
• ? FX risk does not refer to uncertainty about
  future exchange rates

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THE FORWARD FX MARKET

• Forward FX market is the largest component of FX
  market
• Forward rates are available for all major
  currencies
• Forward contracts are for 30, 90, 180 days or
  longer maturities
• Contracts are drawn between banks or between
  banks and their clients

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• Forward market is a decentralized market, like
  the interbank spot market
• Participants are connected by phone and the SWIFT
  network

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FORWARD PREMIUMS AND DISCOUNTS

• We say that a currency is at a forward premium
  when we pay more for forward delivery than for
  spot delivery
• We say that a currency is at a forward discount
  when we pay less for forward delivery than for
  spot delivery

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• Define
• ? Fn(i/j) as the n-year forward exchange rate of
  currency i to currency j
• ? E.g. F1/12(FF/DM) is the one-month forward
  rate of FF to DM if this rate is FF3.5/DM, then,
  a month from today, we will exchange FF for DM at
  this rate

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• Define the forward premium/discount as follows
• Premium/discount (i/j) Fn(i/j) -
  S(i/j)/nS(i/j)
• We divide by n to express the premium/discount in
  annual terms S is the spot exchange rate

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• Notice that
• ? All currencies, except , are quoted in
  European terms (j is the )
• ? This implies that if the above expression is
  positive, then is at a forward premium vs.
  local currency
• ? If above expression is negative, is at a
  forward discount

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• E.g. F1/4(/) 125/, S(/) 115/
• ? Forward rate greater than spot rate
• ? is at a forward premium (verify from above
  formula)
• ? is at a forward discount
• ? we need more to buy a in the forward market

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• If the forward rate and the spot rate are equal,
  we say that the forward currency is flat
• Forward premiums/discounts are expressed in
  percentage terms
• E.g. F1/2(/) 1.4685/, S(/) 1.4780/

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• Percentage premium/discount of vs. is
• (1.4685 - 1.4780)/(1/2 1.4780) 100 -1.286
• Interpretation costs 1.286 percent per annum
  less for forward delivery than for spot delivery

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SPECULATION, FORWARD RATES AND EXPECTED FUTURE
SPOT RATES

• If there are no transaction costs and speculators
  are risk-neutral, then
• ? If F Se then sell forward
• ? If F
• ? The process will result in F Se

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• E.g. Se DM1.8/, F1/12 DM1.78/
• ? Buy forward
• ? Sell in spot market in one month
• ? Expected profit DM0.02/
• ? Through this action, F1/12 increases until it
  is equal to Se
• If F1/12 Se speculators sell forward

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PAYOFF PROFILES OF FORWARD CONTRACTS

• The payoff profile of a forward contract is
  related to the difference between the expected
  future spot rate at the time of the contract and
  the realized spot rate
• If the realized spot rate is higher or lower than
  expected, then there is a gain or loss on the
  contract
• We can present this with a plot called the payoff
  profile of a forward contract