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

How Currency Crisis Happen? u u 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. u u 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

How Currency Crisis Happen? u u 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). u u 4. Heading Behavior: You are just one buffalo and there are thousands of others! u u 5. Contagion: Countries within geographic regions are often closely connected both in real and financial terms. u u 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

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

Currency Statistics

Currency Market Jumps 5

Currency Market Contagion

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

Foreign Exchange Risk Exposure at Merck u Translation and Transaction exposure:Changing the dollar value of net asset and expected transaction cost u Future Revenue exposure: Changing the dollar value of future cash flow u Competitive Exposure: affect labor cost and pricing flexibility u How to measure the exposure from Merck’s point of view: Sales Index Index =  q j0 *s jt  q j0 s j0 

J.P. Mei Approach to FX Risk Management u u Problem: Base year may be out of date.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

 Sales Index: Index =  q j0 *s jt  q j0 s j0  u One need to update the sales index frequently. u One need to focus on the really important key currencies. u The use of key currencies may take advantage of negative correlation as a result of long-short position in different countries. u Choice of hedging instruments: Forward or Spot (Borrow and sell on the spot, invest the proceeds) u Major determinant: credit risk.