Foreign Exchange Risks International Investment

Exchange Risk Exposure Accounting exposure = (foreign-currency denominated assets) – (foreign-currency denominated liabilities) Transaction exposure: uncertainty in the domestic currency value of the transaction using foreign currency Economic exposure = exposure of the value of the firm (the present value of future cash flows) to changes in exchange rates

How to hedge FX risk Use forward contracts, futures or options. Use the domestic currency Speed up payments (collections) of currencies expected to appreciate (depreciate) Slow down payments (collections) of currencies expected to depreciate (appreciate)

FX Risk Premium The forward rate is equal to the expected future spot rate, or F = E t+1 e, if there is no risk premium. If there is a risk premium, F = E t+1 e + (risk premium) The forward rate incorporates a risk premium that induces people to take a risk Is the forward rate an unbiased predictor of future spot rate?

Risk and Risk Aversion Risk of a given portfolio is measure by the variability of its returns. The more variable the return, the less certain about its value. Risk Aversion: the tendency of investors to avoid risk FX risk premium = (F - E t+1 e )/E t

FX Risk Premium Look at CIP again i us – i J = (F - E t )/E t But (F – E t )/E t = [(F – E t+1 e ) + (E t+1 e - E t )]/E t So i us – i J = (E t+1 e - E t )/E t + (Risk premium %)

FX Risk Premium If this FX risk premium = 0, then i us – i J = (E t+1 e - E t )/E t Uncovered Interest Parity (UIP) “The forward rate is an unbiased predictor of the future spot rate”  F = E t+1 e  FX risk premium =0.

Example The dollar-yen spot and 6-month forward exchange rates E $/¥ on Friday 3/22/02 are E t = ¥132.80/$ E t+1 e = ¥131.80/$ F = ¥131.29/$ Then FX risk premium  (F- E t+1 e )/ E t = Expected appreciation of the Yen  (E t+1 e -E t )/ E t = Forward premium  (F- E t )/ E t =

Example (cont’d) The 6-month Eurodollar and Euroyen rates are 2.31% and 0%: i us = and i J = 0 So i us – i J = The expected return from holding a Japanese bond is i J + (E t+1 e - E t )/ E t = < i us =

Market Efficiency Prices reflect all available information  Efficient Market The Fed unexpectedly lowers the interest rate.  An immediate decline of the dollar or E t  In an efficient market, F - E t+1 e = FX risk premium.

Market Efficiency (cont’d) Suppose F > E t+1 e + FX risk premium. An investor would get profits by selling forward currency now (short position in the Euro) and buying it back later. If F < E t+1 e + risk premium, an investor should buy forward currency now (long position in the Euro) and sell it later.

Test for Market Efficiency Statistical tests for the efficiency of the FX market Is there any other variables in addition to the forward rate (F) that can help predict the future spot rate (E t+1 e )? If no, then the forward rate contains all relevant information about the future spot rate.

Foreign Exchange Forecasting There is some evidence that the forward rate is not an unbiased predictor of the future spot rate. But conflicting evidence on the ability of exchange rate forecasting to forecast better than the forward rate.

International Investment Differences in the returns on assets in different countries Diversified portfolio provides lower risk with the same expected return.

International Investment (cont’d) Systematic risk: The risk common to all investment opportunities. Related to Business cycles. Non-systematic risk: The risk that can be eliminated by diversification.

International Investment (cont’d) Direct Foreign Investment (DFI or FDI): actual establishment of a foreign operating unit Portfolio Investment: purchase of foreign securities

International Investment (cont’d) Late 1970s: “Recycling” of the oil money  International bank lending  mid 1980s: Debt crises and non-repayment  Bank lending  Early 1990s: “Emerging market” boom  portfolio investment  Mexico currency crisis (1994)  “Tequila effect”  portfolio investment  Late 1990s: DFI 

Portfolio investment and DFI Portfolio investment Short-term motives  contributes to a financial crisis used for consumption spending Direct foreign investment Long-term commitment used for productive investment involves technological transfer

Capital Flight Risk  or expected return   massive outflows of investment funds; KA  Caused by: Political or financial crisis Capital controls Tax increases Devaluation fear

Capital Inflows Early 1990s: Capital inflows to developing countries (FDI as well as portfolio investment)  Benefits: Capital inflows help the countries finance, for example, domestic infrastructure.

Potential Problems with Capital Inflows A sudden capital inflow  an appreciation of the domestic currency  export   output   unemployment  A sudden capital inflow  KA  & CA  (why?) A sudden capital inflow  FX intervention  money supply   inflation

Policy responses Fiscal restraint: cut gov’t spending and raise taxes (contractionary fiscal policy) Exchange rate policy Capital controls: taxes and quotas in capital flows; raise reserve requirements; restriction on FX transactions.

International Lending and Crisis 1980s: Debt crises in Latin American countries : Mexican financial crisis—Mexico devalued the peso; a large loan from the IMF and the US treasury : Asian financial crises—devaluation in Thailand  financial panics spread to Malaysia, Indonesia, the Philippines and South Korea.

International Lending and Crisis After crises, bank lending  The exposure of international banks in the 1997 Asian financial crises is much smaller than in Latin American debt crises in 1980s.

Asian Financial Crisis Twin crisis: Currency crisis + Bank crisis Currency crisis: fear of devaluation  investors flee a currency   pressure for  capital flight a devaluation

Causes of Asian financial crises External shocks: depreciation of Yen and renminbi Macroeconomic policy: Fixed exchange rates Financial system flaws: “Crony capitalism” Moral Hazard

Defense of Fixed rate and Crisis Pressure for a devaluation (e.g. CA  )  defend the fixed rate (FX intervention, raise interest rate, capital controls)  Speculative attack  abandon the fixed rate—devaluation  (foreign currency denominated) debt 

Financial system flaws A banking system based excessively on directed lending, connected lending, and other collusive personal relations. “Crony capitalism” Bank bailout guarantee by the gov’t  banks take excessive risk (Moral hazard)