One more currency sensitivity question question

stockjaguar

Another currency sensitivity question from Schweser sample exams, told from the point of view of a Canadian investor

Diversified (the stock) is a metal exporter from Arbutia (made up country)

When the Arbutian currency changes by 10%, the value of the Diversified stock changes by 6%. (I understand the negative correlation: as the currency declines, the stock goes up)

Question:

The sensitivity of the Diversified, measured in Canadian Dollars, to changes in the value of the Arbutian currency is closest to:

A) -.6

B) .4

C) 1.6

I'm totally lost

the answer is B

MiniMe7

This one uses the formula R = Rfc +s whisch is just

Return domestic = return Foreign + exchange rate movement

so I would approach this as:

R = -.6 +.1 = +.4 (B)

are you looking for the actual formula, or an explination as to what the formula is implying?

SpyAli

Ok, Diversified is located in arubatia. My "default position" to my own local currency is a sensitivity of 1. However, some firms, such as importers/exporters, will have more or less sensitivity to their own currency.

If the currency moves by 10%, but the firm only moves by 6%, this means i'm not in lock step with the currency. There is a 60% relationship between the sensitivity of firm value to the sensitivity of the local currency.

So 1 (default position) - (.60) = .4

SOmeone please comment on my post, as i also struggle with this area and dont want to be providing false info...

ryanlb

My questions:

1) I knows this sounds really lame, but who/what is the domestic exposure?

2) Who/what is the the foreign currency exposure

3) Who/what is the "local" currency exposure?

tianxin

From the common sense point of view I understand.

We own a foreign stock. The foreign currency goes down 10%. But with this stock, the stock goes up 6% when the currency goes down 10%.

So we have a net return of -4%

but the question asks for the sensitivity

and I can't figure it out. The textbook explanation is difficult p. 501-502

_____________

Let's get back to this formula:

This one uses the formula R = Rfc +s whisch is just

Return domestic = return (local) foreign + exchange rate movement

return (local) foreign = ????????????????? (how did you figure this out?) Is it 6%/10%, and negative because they are an exporting company?

C'mon, if you have the keys, don't make me beg, If I understood it I would help you

thecfawannabe

The company exports --> depreciating local currency means stock price increase for an exporter or lets assume the currency appreciates by 10% and the stock falls by 6%.

So you calculate the local exposure (that is, the exposure of local stock price to local currency change) as change stock / change currency. since we have a negative relationship as explained above, that reads -6/10 = -0.6 = local exposure.

Using the formula provided for foreign exposure you get domestic exposure = local exposure +1
=-0.6 + 1 = 0.4

I think that explains where the -0.6 come from. To understand local vs domestic exposure:
the investor lives in Canada here -> canada = domestic. The investment is in A. --> A. = local. Local exposure is if youre in the country of the investment and consider changes of stock price there vs change in currency. Domestic then refers to the exposure the investor based in another country would have. In this example, the Canadian investor would experience a return that is a mix between the Arbutian currency appreciating vs the CAD and the actual stock return in Arbutian currency (which is negative based on local exposure). If the Arbutian C appreciates it will translate to more CAD for the investor in Canada (his investment is denominated in Arbutian C, so he gains), he can hence offset (some of or all of) the negative stock movement that follows from the local exposure... Hope that makes it a little more clear?!



Edited 2 time(s). Last edit at Wednesday, May 26, 2010 at 02:18PM by Domb.

19831985

Unfortunately I used different info in my example than what was in the original question you gave.

in the original question you had:
Arbutian currency change (relative to Canadian Investor) of 10%,
Diversified security loss of 6%

so...
if foregn currency appreciated by 10% so with no change in Diversified security you gain 10% to your value from the translation.

But the stock goes down by 6% so even though you gain the 10% in currency terms you've lost 6% from the stock return (-.06 +.1 = .04 or 4%)

So that's the RETURN that you receive as the Canadian investor, now you can find the CURRENCY EXPOSURE which is:

Domestic exposure = return/change in spot

ie. domestic exposure = .04/.1 = .4

I interperet this kind of like duration in the fact that when calcing duration you shock the int rates by a small # of bps but the interpretation is if you had shocked them by 100bps

The .4 is the return you would get if the foreign currency changed by 100%. ie. you would see a 40% return

Again, I am not 100% on this, this is just how I interpreted it as I was reading about it.

tarunajwani

Local currency exposure = -.6 (currency up 10%, returns down 6%)

Since we're assuming a Canadian investor's viewpoint, we have to add 1 to -.6 which leaves us with .4.

NO EXCUSES