As Economists, we are concerned with transaction and economic exposure.

Transcription

1 LCTUR Spt 21st Hamza Ali Malik con 3114: Intrnational Financ Fall 2006 Forign xchang Risk Thr typs of forign xchang risk xposur: Translation/Accounting xposur --- diffrnc btwn forign currncy dnominatd assts and forign currncy dnominatd liabilitis. Transaction xposur --- rsulting from th uncrtain domstic currncy valu of a forign currncy dnominatd transaction to b compltd at som futur dat. conomic xposur --- snsitivity of th ral domstic currncy valu of long-trm cash flows to xchang rat changs. As conomists, w ar concrnd with transaction and conomic xposur. Forign xchang risk may b hdgd or liminatd by th following stratgis: Trading in forward, futurs, or options markts. Invoicing in th domstic currncy. Spding (slowing) paymnts of currncis xpctd to apprciat (dprciat). Spding (slowing) collction of currncis xpctd to dprciat. 1

2 Forign xchang Risk Prmium In th analysis rgarding uncovrd intrst rat parity w assumd that th forward R srvs as an unbiasd prdictor of futur spot R. But w may qustion whthr F should b qual to th or whthr thr is a risk prmium incorporatd in th forward rat. In gnral, th ffctiv rturn diffrntial btwn assts of two countris is a function of risk and risk avrsion and is trmd as risk prmium. i i * = f (risk, risk avrsion) Risk --- risk associatd with an asst is th contribution of that asst to th ovrall portfolio risk of th invstor and is usually linkd with variability/volatility of th rturns from that asst. Risk avrsion --- simply mans prfrring lss risk to mor risk and implis that popl must b paid to tak risk. From th covrd intrst rat parity w hav: i i* = F To convrt th LHS to an ffctiv rturn diffrntial w must subtract th xpctd chang in th R from both sids: i i * = F 2

3 or F i i * = --- risk prmium Thus, th ffctiv rturn diffrntial is qual to th prcntag diffrnc btwn th forward and xpctd futur spot R. If RD = 0 RP = 0 If RD > 0 RP > 0 Sinc th xpctd futur spot pric of is lss than th prvailing forward rat. xampl: = $2.10, = $2.00, F = $2. 05 Th xpctd chang in th R = = = % 2.10 F Th forward discount on pound = = = % 2.10 F Th FORX risk prmium = = = % 2.10 Givn th ngativ RP on th $, th xpctd rturn from holding a UK bond will b lss than th domstic rturn on Canadian bonds. If i * = 12.4% and i = 10%, thn th xpctd rturn from holding a UK bond is: i * + = ( 0.048) = or 7.6% But i = 10% ; yt this can b an quilibrium solution givn th risk prmium =

4 If markts ar fficint ( prics rflct all availabl information), thn F would diffr from only by a RP. If this wr not th cas, and F > + RP, an invstor could raliz crtain profits. How? Sll forward now and buy spot in th futur. xampl: Suppos th spot xchang rat btwn th dollar and th uro is: $/ = Th on yar intrst rat on a dollar-dnominatd bond is 7% and th on yar intrst rat on a similar uro-dnominatd financial instrumnt is 5%. What should b th forward prmium or discount? What should b th on-yar forward rat? Now assum that th maturity priod is six months as opposd to on yar. What should b th forward prmium or discount? What should th forward rat b now? What would profit-sking arbitragurs do if th on-yar forward xchang rat turns out to b: $/ = 0.98? If th xpctd spot xchang rat in on-yar is: $/ = 0.94, what is th risk prmium? Answr: Th covrd intrst parity rlationship is: i t F = i t +. If th domstic intrst rat is 7% and th forign intrst rat is 5%, thn thr will b a 2% forward prmium on forign F 0.95 currncy. Th forward on-yar rat would b: 0.07 = = If th maturity priod is six months, thn th covrd intrst parity rlationship bcoms: i t F 12 = i t +. Thus, th forward prmium would b 4%. Th six-month forward rat 6 4

5 F would b: 0.07 = = If th on-yar forward rat turns out to b 0.98, thn th arbitragurs will buy spot at 0.95 and sll forward at F Risk prmium = = = or 3.1%. Forign xchang Forcasting Two typs of modls: i) Fundamntal modl forcasts R basd on variabls that ar blivd to b important dtrminants of R. For xampl, rlativ output growth rats, inflation diffrntial, intrst rat diffrntial and th stanc of fiscal and montary policy. ii) Tchnical trading modl uss th past history of R to prdict futur movmnts. How should w judg a forcast of? In gnral, othr things qual, w should prfr a smallr forcast rror to a largr on. In practic, howvr, othr things ar not qual; so to b succssful, a forcast should b on th corrct sid of th modl. 5

6 xampl: = 120 = $1 F = 115= $1 Mr. A forcasts = 106 = $1 Mr. B forcasts = 116 = $1 Ralizd = 113 = $ rror in Mr. A s forcast = *100 = 6.2% rror in Mr. B s forcast = *100 = 2.6% 113 A Japans firm has a $1 million du in 12 months, should it covr th dollar rcivabl with a forward contract or wait and sll $ in th spot markt in 12 months? If follow Mr. B: firm would wait and sll $ in th spot markt, but would nd up rciving 113 million. If follow A: firm would sll (tak a short position in $) forward and rciv 115 million. 6