LOS l: Define currency exposure and explain exposures in terms of correlations.

Q1. 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?

A)   Local currency return = α + β (world market return).

B)   Domestic currency return = α + β (world market return).

C)   Domestic currency return = α + β (exchange rate movement).

Q2. 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?

A)   2.3.

B)   1.3.

C)   0.3.

Q3. 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:

A)   security exaggerates the impact of currency movements.

B)   domestic currency γ is greater than one.

C)   security provides a natural hedge against currency movements.

LOS l: Define currency exposure and explain exposures in terms of correlations. fficeffice" />

Q1. Paul McCormack is a ffice:smarttags" />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?

A)   Local currency return = α + β (world market return).

B)   Domestic currency return = α + β (world market return).

C)   Domestic currency return = α + β (exchange rate movement).

Correct answer is C)        

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.

Q2. 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?

A)   2.3.

B)   1.3.

C)   0.3.

Correct answer is A)

The investor estimated γ^FC = 1.3. To translate local (or FC) exposure to domestic currency exposure, we use: γ = γ^FC + 1. Hence, the domestic currency exposure is: γ = γ^FC + 1 = 1.3 + 1 = 2.3.

Q3. 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:

A)   security exaggerates the impact of currency movements.

B)   domestic currency γ is greater than one.

C)   security provides a natural hedge against currency movements.

Correct answer is C)

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.