Paul McCormack is a U.S. investor interested in valuing a Japanese security. Which of the following regression equations would be useful to McCormack in assessing the currency exposure of the Japanese security to changes in the dollar/yen exchange rate?
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To assess currency exposure, regress domestic currency returns against exchange rate movements [Domestic currency return = α + β (exchange rate movement)]. In this formulation, β would be an estimate of the currency exposure and would likely be called γ if used in the international capital asset pricing model.
A French investor holds a U.K. security. The investor has estimated the currency exposure in local currency terms to be 1.3. What is the currency exposure in domestic currency terms?
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The investor estimated γFC = 1.3. To translate local (or FC) exposure to domestic currency exposure, we use: γ = γFC + 1. Hence, the domestic currency exposure is: γ = γFC + 1 = 1.3 + 1 = 2.3.
Suppose that a U.K. investor holds a U.S. security. The U.S. security has a negative correlation with changes in the value of the U.S. dollar in local currency terms. What does the negative correlation mean for the U.K. investor? The:
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A negative correlation means that as the value of the dollar falls (depreciates) the value of the security rises. Hence, the security provides a natural hedge against exchange rate movements to the U.K. investor. If the correlation is negative, the local currency γ will be less than zero.
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