Reading 70: LOS j ～ Q1- 3 class, black, style

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1．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)   local currency γ is greater than one.

C)   domestic currency γ is greater than one.

D)   security provides a natural hedge against currency movements.

2．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)   1.3.

B)   2.3.

C)   0.3.

D)   -0.3.

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

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

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

D)   Exchange rate movement = α + β (gross domestic product).

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1．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)   local currency γ is greater than one.

C)   domestic currency γ is greater than one.

D)   security provides a natural hedge against currency movements.

The correct answer was D)

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.

2．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)   1.3.

B)   2.3.

C)   0.3.

D)   -0.3.

The correct answer was B)

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.

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

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

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

D)   Exchange rate movement = α + β (gross domestic product).

The correct answer was B)

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.