Emerging Financial Markets 5: Currency Trading & Risk Management

1. Emerging Financial Markets 5: Currency Trading & Risk Management Prof. J.P. Mei

2. How Currency Crisis Happen? • 1. The "first generation" currency crisis model represented by Krugman (1979) and Flood and Garber (1984): Strong incentive to engage in inconsistent policies during elections by pursuing expansionary monetary and fiscal policies while holding exchange rates fixed to ensure price stability or other policy objectives. • 2. The "second generation" model of Obstfeld (1994): Contradicting motives. Jobs and stability (Banking problems). In such a model, the cost of defending the currency increases when people suspect that the government is leaning towards abandoning the fixed rate. 5

3. How Currency Crisis Happen? • 3. There is a possibility that fixed rates may be abandoned but not inevitable. Massive exit will make this inevitable. Self-fulfilling exchange rate crises (see, Hong Kong). • 4. Heading Behavior: You are just one buffalo and there are thousands of others! • 5. Contagion: Countries within geographic regions are often closely connected both in real and financial terms. • 6. Contingent investment or "real options": foreign capital flow to Asia from a huge $93 billion inflow in 1996 to a $12 billion net outflow in 1997. 5

4. Currency Market Movement and Volatility(Notes for the following table ) • Negative Means reflects devaluation against dollar. • Some markets have low volatility due to currency peg. (Volatility could be under-estimated) • The presence of short-run positive serial correlation for most countries. • Long-term mean reversion (negative serial correlation) • Jumps as a result of government intervention and speculative attacks (Thailand). • Excess skewness and kurtosis may lead to under-pricing of derivatives based on conventional approach. • There is cross-correlation and currency market contagion in the short-run. 4

5. Currency Statistics

6. Currency Market Jumps 5

7. Currency Market Contagion

10. Foreign Exchange Risk Exposure at Merck Why should the management care? • It increases the volatility of earnings. • It make it difficult to maintain a stable dividend policy. • It may scare away Pension fund investors. • It could impact the firm’s R&D. Why it should not care too much in an efficient capital market? • The risk may be diversifiable. • Systematic risk gets compensated.

11. Foreign Exchange Risk Exposure at Merck • Translation and Transaction exposure:Changing the dollar value of net asset and expected transaction cost • Future Revenue exposure: Changing the dollar value of future cash flow • Competitive Exposure: affect labor cost and pricing flexibility • How to measure the exposure from Merck’s point of view: Sales Index Index = S qj0*sjt /(S qj0 sj0 )

12. J.P. Mei Approach to FX Risk Management • Problem: Base year may be out of date. • Identify 20% of the country that contribute over 80% of the sales. (Narrow down to 8 currencies) • Use a combination of 1, 2, 3, 4, 5, 6, and 7 currencies, until you get a combination that explain enough variance (good R2) and the coefficients are your hedge ratio. (What are the most important factors?) • Salest=a+a1f1t +a2f2t +…+qkfkt +et • Main Weakness • Ignore Translation exposure • Ignore Competitive exposure

14. Sales Index: Index = S qj0*sjt /(S qj0 sj0 ) • One need to update the sales index frequently. • One need to focus on the really important key currencies. • The use of key currencies may take advantage of negative correlation as a result of long-short position in different countries. • Choice of hedging instruments: Forward or Spot (Borrow and sell on the spot, invest the proceeds) • Major determinant: credit risk.