Sec. 8.2 – 8.3 Exchange Risk

1. Sec. 8.2 – 8.3 Exchange Risk

2. What is a Short Position? • Liabilities > assets • If you are borrowing Yen to buy $ denominated assets? Are you short or long? • Who is long? • Who is long on $? Who is short?

3. What Happens if the Yen falls?

4. Definition • Foreign Exchange Risk = Variability in the value of an exposure that is caused by uncertainty about exchange rate changes.

5. Risk • Risk is a function of 2 variables • Volatility of exchange rates • Degree of exposure • Degree of Risk • Low = rate fixed, low exposure • High = rate volatile, high exposure • Consequences

6. Calculation of Risk • Degree of Exposure X Standard Deviation of Percent Change in Exchange Rates • Notes • Change Currency to Home Currency • % Change allows us to compare across currencies

7. Example • Example: • John has 200 Euros in receivables due in 6 months. Forward Exchange rate is 1.50$/Euro. Standard Deviation of Percent Change is10%. What is the Exchange Risk? • Step 1 – Convert Exposure to home currency: 1.50$/Euro X 200 Euro = $300

8. Example cont. • Step 2 – Multiply Exposure by SD of % Change: $300 X 10% = $30 • Probabilities: • One SD, 68% probability the receivables will be worth between $270 - $330 • Two SD, 95% probability the receivables will be worth between $240 - $360 • Three SD, 99.7% probability the receivables will be worth between $210 - $390

9. Example cont.

10. Value at Risk The most we can lose over some period, given normal market conditions Usually 99% confidence level

12. Example 2 • Manny is expecting to receive 400 UK Pounds in 1 month. Forward exchange rate is 2.00$/Pound. Using Table 8-1, What will be the exchange risk? • 2.00 $/Pound X 400 Pound = $800 • Monthly Un-annualized SD = 2.66 • SD = 800 X 2.66% = $21,28 • 68% Probability Manny will receive between $778.72 and $821.28

13. Ex Risk with Multiple Currencies • More Currencies = more complex • Exposures and risks cannot simply be added together • Must Consider correlation of movements in relation to home currency

15. Calculation • 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 500 percentage points. From Table 8-2, correlation is 0.624 and the covariance is 346.5. What is the exchange risk associated with $100 of Yen and $100 of DM?

16. Calculations cont. • 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

17. Review Problem 2 Suppose Sweta has $100 worth of accounts payable in C$ and $100 worth of accounts payable in A$, both due in 90 days, and want to know the SD of the portfolio of payables. She knows that the 90 day $/C$ % change is 8, the $/A$ % change is 20, and the correlation between the two is .35 What is SD of her portfolio?

18. Review Problem 2 The covariance between percentage changes in $/C$ and $/A$ is .35*8*20 or 56, so the variance of the portfolio is: =100^2(8^2)+100^2(20^2)+2(100^2)(56) = 100^2 [8^2+ 20^2+2(56)] = 100^2[64+400+2(56)] VAR= 100^2(576) SD=100(24) Or $24, because the standard deviations are in percentage points

19. Delta hedging The process in finance of setting or keeping the delta of a portfolio of financial instruments zero, or as close to zero as possible - where delta is the sensitivity of the value of a derivative to changes in the price of its underlying instrument. This is achieved by entering into positions with offsetting positive and negative deltas such that these balance out to bring the net delta to zero

20. Mathematically Delta is the partial derivative of the instrument or portfolio's fair value with respect to the price of the underlying security , and indicates sensitivity to the price of the underlying. Therefore, if a position is delta neutral (or, instantaneously delta-hedged) its instantaneous change in value, for an infinitesimal change in the value of the underlying, will be zero

21. Any Questions?