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The risk of foreign Exchange Exposure

The risk of foreign Exchange Exposure. 1. Introduction 2. Exchange Risk with “One Currency” 3. Exchange Risk with “Multiple Currencies” 4. Conclusion. 1. Introduction. Before: We have already talked about the different kinds of Foreign Exchange Exposure: Translations Exposure (Accounting)

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The risk of foreign Exchange Exposure

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  1. The risk of foreign Exchange Exposure 1. Introduction 2. Exchange Risk with “One Currency” 3. Exchange Risk with “Multiple Currencies” 4. Conclusion

  2. 1. 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.

  3. 2. Exchange Risk with one currency • Three types of exposure: • Exchange rate is fixed • No variability s2 = 0 (No Risk) • Exchange rate is variable • Low variability s2> 0 (Low Risk) • High Variability s2>>> 0 (High Risk)

  4. 2. Exchange Risk with one currency • Suppose: • -Future Exchange rate is $2/£ • - s = 15 % 68% 95% 95% z $1.4/£ $1.1/£ $1.7/£ $2/£ $2.6/£ $2.9/£ $2.3/£

  5. 2. Exchange Risk with one currency Suppose: £1’000,000 Receivable (£1m) 68% 95% 95% z $1.4m $1.1m $1.7m $2.3m $2m $2.6m $2.9m

  6. 2. Exchange Risk with one currency What to do as managers: Analyze the volatility of the exchange rate s

  7. 3. Exchange Risk with multiple currencies • Is more complex • It is necessary to analyze the correlation among currencies.

  8. 3. Exchange Risk with multiple currencies

  9. 3. Exchange Risk with multiple currencies Risk = Sum of exchange Variances + Sum of Covariance of particular currencies • Risk = Sum of exchange Variances + Sum of Covariance of particular currencies • Example: • Variance of annual percentage changes in Yen/$ is 600 percentage points, and Variance of DM/$ is 550 percentage points. From Table 8-2, correlation is 0.624 thus the covariance is 346.5. What is the exchange risk associated with $100 of Yen and $100 of DM?

  10. 3. Exchange Risk with multiple currencies • 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

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

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