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Foreign Exchange Risks

Foreign Exchange Risks. International Investment. 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

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Foreign Exchange Risks

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  1. Foreign Exchange Risks International Investment

  2. 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

  3. 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)

  4. FX Risk Premium • The forward rate is equal to the expected future spot rate, or F = Et+1e, 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?

  5. 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

  6. FX Risk Premium • Look at CIP again ius – iJ = (F - Et)/Et • But (F – Et)/Et = [(F – Et+1e) + (Et+1e - Et)]/Et • So ius – iJ = (Et+1e - Et)/Et + (Risk premium %)

  7. 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.

  8. 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

  9. 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

  10. 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.

  11. 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.

  12. 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+1e)? • If no, then the forward rate contains all relevant information about the future spot rate.

  13. 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.

  14. International Investment • Differences in the returns on assets in different countries • Diversified portfolio provides lower risk with the same expected return.

  15. 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.

  16. International Investment (cont’d) • Direct Foreign Investment (DFI or FDI): actual establishment of a foreign operating unit • Portfolio Investment: purchase of foreign securities

  17. 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 

  18. 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

  19. Capital Flight • Risk  or expected return  massive outflows of investment funds; KA  • Caused by: Political or financial crisis Capital controls Tax increases Devaluation fear

  20. 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.

  21. 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

  22. 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.

  23. 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.

  24. 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.

  25. Asian Financial Crisis • Twin crisis: Currency crisis + Bank crisis • Currency crisis: fear of devaluation  investors flee a currency   pressure for  capital flight a devaluation

  26. Causes of Asian financial crises • External shocks: depreciation of Yen and renminbi • Macroeconomic policy: Fixed exchange rates • Financial system flaws: “Crony capitalism” Moral Hazard

  27. 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 

  28. Financial system flaws • A banking system based excessively on directed lending, connected lending, and other collusive personal relations. “Crony capitalism” • Bank bailout guarantee by the gov’t  banks take excessive risk (Moral hazard)

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