The risk of foreign Exchange The risk of foreign Exchange ExposureExposure

1. Introduction

2. Exchange Risk with “One Currency”

3. Exchange Risk with “Multiple Currencies”

4. Conclusion

1. Introduction1. Introduction

- Before: We have already talked about the different kinds of Foreign Exchange Exposure:

- Translations Exposure (Accounting)

- Transaction Exposure (Accounting)

- Economic Exposure (Economic)

- Now: We will analyze the RISK associated to this exposure.

2. Exchange Risk with one currency2. Exchange Risk with one currency

• Three types of exposure:– Exchange rate is fixed

• No variability = 0 (No Risk)

– Exchange rate is variable• Low variability 0 (Low Risk)

• High Variability 0 (High Risk)

2. Exchange Risk with one currency2. Exchange Risk with one currency

z$1.1/£ $1.4/£ $1.7/£ $2/£ $2.3/£ $2.6/£ $2.9/£

Suppose:

-- Future Exchange rate is $2/£

= 15 %= 15 %

68%

95%

95%

2. Exchange Risk with one currency2. Exchange Risk with one currency

z$1.1m $1.4m $1.7m $2m $2.3m$2.6m $2.9m

Suppose: £1’000,000 Receivable (£1m)

68%

95%

95%

2. Exchange Risk with one currency2. Exchange Risk with one currency

What to do as managers:

Currency (%)

Euro 12.84 UK Pound 12.65 Swiss Franc 13.52 Canadian Dollar 4.78 Japanese Yen 13.06 Australian Dollar 9.84 Mexican Peso 34.33 Argentine Peso 108.49 Chilean Peso 16.49 Brazilian Real 104.21

Analyze the volatility of the exchange rate

3. Exchange Risk with multiple currencies3. Exchange Risk with multiple currencies

- Is more complex

- It is necessary to analyze the correlation among currencies.

3. Exchange Risk with multiple 3. Exchange Risk with multiple currenciescurrencies

UK Pound French FrancGerman MarkItalian Lira Swiss FrancCanadian DollarJapanese Yen Mexican PesoUK Pound 1French Franc 0.703 1German Mark 0.715 0.956 1Italian Lira 0.746 0.894 0.863 1Swiss Franc 0.698 0.858 0.899 0.787 1Canadian Dollar 0.179 0.09 0.058 0.153 0.039 1Japanese Yen 0.486 0.605 0.624 0.504 0.678 0.035 1Mexican Peso -0.047 -0.115 -0.21 0.2 -0.184 -0.049 -0.072 1

Correlation Matrix of Different currencies

3. Exchange Risk with multiple 3. Exchange Risk with multiple currenciescurrencies

Risk = Sum of exchange Variances + Sum of Covariance Risk = Sum of exchange Variances + Sum of Covariance of particular currenciesof particular currenciesExample: Example:

Variance of annual percentage changes in Yen/$ is Variance of annual percentage changes in Yen/$ is 600 percentage points, and Variance of DM/$ is 550 600 percentage points, and Variance of DM/$ is 550 percentage points. From Table 8-2, correlation is percentage points. From Table 8-2, correlation is 0.624 thus the covariance is 346.5. What is the 0.624 thus the covariance is 346.5. What is the exchange risk associated with $100 of Yen and $100 exchange risk associated with $100 of Yen and $100 of DM?of DM?

Risk = Sum of exchange Variances + Sum of Covariance Risk = Sum of exchange Variances + Sum of Covariance of particular currenciesof particular currencies

3. Exchange Risk with multiple 3. Exchange Risk with multiple currenciescurrencies

• 100^2Var(Ry) + 100^2Var(Rdm) + 2(100^2)Cov(Ry,Rdm)

• Var = 100^2(600+500+2(346.5)) = 100^2*1793• SD = Square Root of 100^2*1793 = 4234 cents or

$42.34

4. Conclusion4. Conclusion

• As managers we have to take into account the risk of our exposure in different currencies.