explain the concept of currency risk. how can inflation and interest rates create currency risk?

Exchange Rate Risk

It is the exchange rate risk involved in translating earnings and capital of a subsidiary in a foreign country to the reporting currency of the parent.

From: Economic Capital , 2009

Renewable project finance structures and risk allocation

Santosh Raikar , Seabron Adamson , in Renewable Energy Finance, 2020

Currency

Currency risks are relevant for international project financing. Currency risks may arise to the extent revenues, operating expenses, and fuel costs are denominated in a currency different from the one for financing. Typically, debt financings for large international projects are denominated in major currencies such as euros, US dollars, and Japanese yen. Therefore, a cross-currency swap may be necessary in order to hedge the currency risks to the extent any currency mismatch exists.

The tenor for debt financing is linked to the term of the revenue contract, which may extend to the useful life of the project, especially in projects with a useful life that extends 20 years or beyond. Certain currencies, especially in emerging markets, do not have the depth in the commercial swaps market to absorb the size of the deals for the tenor-matching financing. Therefore, sponsors may need to access cross-currency swap facilities available from multilateral institutions.

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Fund investments and currency movements1

Peter Cornelius , in International Investments in Private Equity, 2011

Publisher Summary

This chapter discusses currency risk investors in private equity funds face at different stages of the investment process. Currency risk in private equity is material, which becomes clear when one examines the impact of currency movements on fund returns. Depending on the perspective one takes, changes in the exchange rate have on average increased or reduced private equity fund returns by a few hundred basis points. Similarly, cross-border investments made by individual funds have been subject to currency risk. Although some deals have benefited from favorable exchange rate changes, others have suffered from adverse movements. Exchange rate changes are largely unpredictable. Exchange rates are nonstationary and may deviate from purchasing power parity for prolonged periods. Forward rates are very poor predictors of future spot rates, and to make things worse, the specific investment characteristics of private equity strictly limit the potential for hedging currency risk through traditional strategies. However, these rather dismal observations should not lead us to abandon international investing. In fact, as markets become increasingly integrated, it will become increasingly difficult to avoid foreign currency exposure. Instead, investors should embrace currency risk, in the same way as they face other investment risks. Importantly, this entails incorporating foreign exchange risk in the due diligence process and benchmarking approaches investors employ.

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An Introduction to Derivative Pricing

S.J. Garrett , in Introduction to the Mathematics of Finance (Second Edition), 2013

Solution

To remove the exchange rate risk (i.e., currency market risk), the manufacturer could enter into a futures contract to sell US$ in exchange for sterling in 3 months' time. This fixes the exchange rate in advance, and the company is no longer exposed to adverse movements in the exchange rate. If the standardized unit of a currency future is $1,000, the company would enter into 500 3-month futures contracts that require the delivery of US$ at expiry for a pre-agreed amount of sterling.

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Stock Markets, Derivatives Markets, and Foreign Exchange Markets

Rajesh Kumar , in Strategies of Banks and Other Financial Institutions, 2014

5.3.8 Foreign Exchange Risk Management

Foreign exchange risk is also known as exchange rate risk or currency risk. This risk arises from unanticipated changes in the exchange rate between two currencies. Multinational companies, export import businesses, and investors making foreign investments face exchange rate risks. When a currency falls in value in relation to other currencies, the currency is said to depreciate in value, and when the currency rises in value relative to other currencies, it is said to appreciate in value. Goods and services in countries where the currency has depreciated will become cheaper for foreign buyers. In the case of currency appreciation, a country's goods and services become more expensive for foreign buyers.

Foreign exchange risks can be classified into economic and translation exposure. Economic exposure refers to risks in which changes in economic conditions will adversely impact the investments or operations of a firm. For example, sovereign debt default by a country would affect the exchange rate of the currency. Economic exposure leads to possible changes in the firm's cash flows. The unexpected changes in the exchange rate will affect the market value of the firm. Economic exposure is the combination of transaction exposure and operating exposure. Transaction exposure arises when the future cash flows of the firm are affected by changes in the currency exchange rate. It is the gain or loss arising when converting the currencies. Companies involved in imports and exports face transaction exposure. Managing transaction exposure is an integral part of the Treasury risk management function of corporations. Operating exposure is the degree of risk that a company is exposed to when shifts in exchange rates affect the value of certain assets of the business thereby impacting the overall profitability of the company.

Translation exposure is also known as accounting exposure. Accounting exposure measures the impact of changes in exchange rate on the financial statements of a company. Translation exposure arises when the financial statements of overseas subsidiaries are consolidated into a parent company's financial statement. The performance of an overseas subsidiary in home-based currency can be affected to a greater extent if the exchange rate fluctuation happens in relation to the currency in which the subsidiary cash flows occur.

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Regulatory and Political Risks

E.R. Yescombe , in Principles of Project Finance (Second Edition), 2014

§11.4.1 Currency Convertibility and Transfer

Following on from the macro-economic issues relating to exchange-rate risks (cf. §10.5), this section deals with the risks of currency convertibility and transfer. Two processes have to be carried out in this respect:

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sufficient revenues have to be converted into the foreign-currency amounts required by lenders and investors; and

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these foreign-currency amounts have to be transferred out of the Host Country to lenders and investors. (Foreign currency may also be required to pay for fuel or other operating costs.)

If a project is able to rely on the free international financial markets that exist in developed countries, the only real currency risk is that of an adverse movement of the exchange rate between the domestic and foreign currencies (i.e. devaluation of the local currency, discussed in §10.5). However, if a country gets into economic difficulties and so runs short of foreign-currency reserves, it may totally forbid either the conversion of local currency amounts to foreign currencies or the transmission of these foreign currencies out of the country. In effect, at this point the Host Country has defaulted on its foreign-currency debt. One of the standard provisions of a Government Support Agreement (cf. §11.7) is a Host Government or central bank guarantee of foreign-exchange availability and transfer, but if the Host Country has no foreign-exchange reserves this guarantee will be of little value.

Apart from complete unavailability of foreign currency, the worst problem of this nature likely to be faced by a project in a developing country is a catastrophic devaluation of the Host Country's currency (cf. §10.5.5). A Host Government guarantee of an Offtaker's/Contracting Authority's payment liabilities may also be of limited value in this situation.

Lenders assess the degree of these risks by examining the macro-economic position, balance of payments, and foreign debt levels of the Host Country. If the country has a well-managed and sound economy, then lenders may find the risk acceptable, but if not mitigation of these risks is required.

Apart from political risk guarantees or insurance (cf. Chapter 16), there are some other possible ways of mitigating the risks (but seldom entirely eliminating them):

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Enclave Projects;

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offshore reserve accounts;

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the 'Angola Model'.

Enclave Projects . If a project's revenues are paid in foreign currencies from a source outside the Host Country, in principle the project can thus be insulated against both currency exchange and transfer risks. Because the foreign currency never arrives in the country, it cannot be restricted from leaving it, and the foreign-currency revenues can be retained to service foreign- currency debt raised outside the country. This may be a feasible approach if the project involves production of a commodity for export, for example, oil, gas, or minerals, or the sale of electricity across a border.

Lenders find generally Enclave Projects in developing countries more attractive than those that do not generate their own foreign currency earnings from outside the Host Country. As the term implies, they are relatively isolated from what lenders consider to be one of the main risks of lending to developing countries—that of failure to pay foreign-currency debt—and this approach can mean that a developing country may be able to raise foreign currency for development of its resources that would not be otherwise possible. In a similar way, rating agencies may give a higher credit rating to a bond issued by an Enclave Project than to the sovereign debt of the country in which the project is located.

Typical factors that would create a feasible Enclave Project are:

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importance of the sale of the commodity to the country's economy and balance of payments;

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a limited market for the commodity inside the country (so it is unlikely to be diverted for domestic use);

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an infrastructure oriented towards exports (pipelines, ports, etc.), again to avoid diversion;

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sales through a third party with a good credit standing, located outside the jurisdiction or control of the Host Country;

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direct payment of revenues to an SPV or escrow account outside the Host Country;

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difficulty of diverting payments elsewhere.

The issue with Enclave Projects from the Host Country point of view is that they lose control over what may be their most important export earnings, and so are less able to manage their foreign currency reserves and balance of payments situation in the way they consider appropriate, which they may consider a form of economic colonialism. Enclave projects, however, are a way of raising development finance on more attractive terms for a project in a country with a poor credit rating.

Use of Offshore Reserve Accounts. Even if the Project Company's revenues are not being generated in foreign currencies and held outside the Host Country, the currency-exchange and transfer risk can be mitigated for a limited period by the use of offshore Reserve Accounts. As described in §14.4.1, lenders normally require a Debt-Service Reserve Account (DSRA) to be built up so that these funds can be used to deal with temporary problems in debt payments. If the DSRA is maintained in foreign currency outside the Host Country, it can also be used to cover temporary problems in obtaining foreign currency for debt service. Other Reserve Accounts to accumulate cash for specific purposes can also be set up offshore.

Lenders therefore prefer overseas Reserve Accounts for projects in countries with poor credit ratings, but this may be difficult in countries with strict exchange controls, where domestic companies are not allowed to have such accounts (cf. §8.8.4).

The ' Angola Model '. The Project Company could enter into an arrangement under which it barters its product or services in exchange for a commodity that can then be exported and produce foreign currency, thus creating an Enclave Project in two stages. This procedure is known as counter-trade.

Counter-trade played a limited part in projects for developing countries until the creation of what is now called the 'Angola Model' first provided by the Export-Import Bank of China (cf. §16.4.3) in Angola in 2004. ⁴ This has now been applied by China Exim in various African countries. It is in effect a counter-trade transaction—the bank provides finance for infrastructure development (e.g. a road, which would be built by a Chinese contractor), but is repaid from the proceeds of a natural-resources project being undertaken by Chinese investors. This approach does raise some issues, in particular the linkage between the two projects (what happens if the natural resources project fails?), and how changes in commodity prices affect the transaction. However it has brought infrastructure development, at least in a limited way, to African countries which would otherwise not have been able to make such investments.

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Return and Risk Appraisal

Piotr Staszkiewicz , Lucia Staszkiewicz , in Finance, 2015

6.4.1 Risk and Uncertainty

Risk = possible to measure (known distribution)

Uncertainty = impossible to measure (unknown distribution)

There is another distinction between risk and uncertainty. A risk situation for an individual is when the uncertainty relating to the situation may affect his or her individual wealth.

Consider:

Mark is a sole trader in construction and is about to enter into a contract to construct a house for 600,000 euros, payable in 2 months' time. He can build houses if the temperature outdoors is above 5°C. He is unsure about the weather. If it is colder than 5°C, Mark will not be able to work and he will make a loss, otherwise he will be able to gain from the contract.

John is a teacher and he is also unsure about the weather. If it is below 5°C, he will conduct lectures in the lecture room, otherwise he will conduct his lectures outside.

How does the situation differ for Mark and John?

Solution:

Mark faces a risk situation, whereby the realization of the scenario (i.e., it is colder than 5°C) affects his wealth, whereas John faces uncertainty, as the realization of the scenario does not affect his wealth.

Risk in legislation – being responsible on the basis of risk versus responsibility on the basis of damage caused. There is a different understanding of risk in finance compared with legal science.

Risk is also meant as the mental ability to act on predictions of future events.

Risk in terms of financial analysis ends up with the cash outflow. Thus, there is no financial risk if we cannot convert the source of risk into the cash flows.

Risk is usually defined by a risk factor, for example, currency risk, market risk, default risk, and so on. The other approach to risk is to assess the changeability of the output. Thus, there are three basic concepts of risk assessment:

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volatility – analysis of the risky output,

•

sensitivity – analysis of factors having an impact on the risk,

•

structure mismatch – reduces structure into risk value.

Basic groups of risk measurement methods

The different risk measurement methods are usually used for different instruments, duration is typically used for bonds, Greeks for options, whereas beta is a risk measure for a portfolio. The description of the specific methods are linked to the groups of theories or instruments; they are discussed in their relevant sections.

Example:

List different examples of risk measurement, together with the arguments for and against each one.

Solution:

Type of Measure	Description	Advantages	Disadvantages
Standard deviation (variance square root)	Shows average distance to mean	Easy to use, well-known form of statistical measurement	Captures a neutral concept of risk
Derivative	Shows the impact of small changes to input against output	Well-known in mathematics (a limit)	It shows only changes and behavior for small changes, it is not feasible for long-term analysis
Value at risk	Shows risk as the value which is unlikely to be exceeded	Can capture different instruments together, easy to explain	Difficult to measure on a continuous basis if simulation must be applied
Mismatch of structure	Tries to capture divergences from a given pattern	Applicable for complex issues	Measurement is subject to a judgmental decision

Coefficient of variation is a combined method of measuring both return and risk. It follows the following formula:

(6.21) $\text{CV}=\frac{\sigma }{Expectedreturn}$

where σ denotes the standard deviation of returns, and expected return is assumed not to be negative.

An object (instrument, project) can be characterized by a vector (return, variance of return), where return is the measurement of profitability and variance is the measurement of risk. Thus, the most profitable projects are those with the highest return and the lowest variance.

Example:

A share in ABC plc has the following returns: 5, 10, 11, 5, –6. A share in WRS plc has the following returns: 7, 2, 15, 4, 17. Which share is more risky?

Solution:

An average return of the shares:

ABC plc = (5 + 10 + 11 + 5 − 6)/5 = 5

WRS plc = (7 + 2 + 15 + 4 + 17)/5 = 45/5 = 9

The variance of the returns is:

ABC plc = (5 − 5)² + (10 − 5)² + (11 − 5)² +(5 − 5)² + (−6 − 5)² /5 = 0 + 25 + 36 + 0 + 121/5 = 182/5= 36.4

WRS plc = (7 − 9)² + (2 − 9)² + (15 − 9)² + (4 − 9)² + (17 − 9)² /5 = 4 + 49 + 36 + 25 + 64 = 178/5 =35.6

Thus:

(ABC plc) 36.4 > 35.6 (WRS plc)

The ABC plc share is the more risky.

Note that the method of variance approach does not define the period under review; it is a judgmental (arbitrary) decision.

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The Foreign Exchange Market

Cristina Terra , in Principles of International Finance and Open Economy Macroeconomics, 2015

3.3.2 Covered Interest Rate Parity

Reorganizing the previous equation, we have the covered interest rate parity condition:

(3.9) $\frac{{}_{t}F_{t+1}}{{\mathrm{S}}_t}=\frac{1+{\mathrm{i}}_t}{1+{\mathrm{i}}_t^{*}}.$

This parity condition is called covered since it is covered for the exchange rate risk. It is commonly written in log, so we take the natural logarithm from the covered interest rate parity, Eq. (3.9), to get:

(3.10) ${}_{t}f_{t+1}-s_t={\mathrm{i}}_t-{\mathrm{i}}_t^{*},$

where $s\equiv \ln (\mathrm{S})$ , $f\equiv \ln (F)$ , and $i\equiv \ln (1+\mathrm{i})$ .

It is interesting to note that, for an investor, it is not the exchange rate that matters, but its variation over time. A change in the exchange rate between the time of buying and selling a foreign asset alters its value in domestic currency. If a large exchange rate depreciation is expected in the foreign country, for example, the interest rate offered on the asset must be high enough to compensate the loss caused by currency depreciation.

There are two crucial assumptions for the covered interest rate parity to hold true: free capital mobility and the perfect substitutability of assets. When there are restrictions to the international flow of capital, the arbitrage between the potential different returns cannot be made and, therefore, the interest rate parity may not be satisfied.

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Risk Management: Hedging and Diversification

Geoffrey Poitras , in Risk Management, Speculation, and Derivative Securities, 2002

C THE OPTIMAL HEDGE RATIO FOR A SINGLE FOREIGN ASSET

In deriving Benari's condition, the following assumption was used: The currency risk of the foreign asset could be fully hedged at t = 0. In practice, it is not always possible to determine the terminal payoff on the foreign asset at t = 0. In other words, the exact size of the foreign currency hedge will be indeterminate because the precise payoff on the foreign asset at t = 1 will be unknown when the hedge is initially established. Though it may be possible to start the hedge at the t = 0 market value and sequentially increment the hedge at discrete intervals, such a strategy would be path dependent and would give an uncertain outcome. Another possible approach would be to set the size of the hedge position equal to the expected value of the position at the end of the hedge horizon. The success of this approach would depend on the accuracy of the estimate of future values.

Eun and Resnick (1994, p. 147) examine this point in more detail. Consider the return on a hedged foreign asset position, where the size of the hedge position is determined by estimating the value of the position at the end of the investment horizon. Unexpected gains or losses are left uncovered to be converted back at S ₁. Letting R_eh be the return to a hedged foreign asset where the size of the hedge position is established by estimating the value of the position, it follows that:

$1+R_{\mathit{eh}}=\left(1+E\left[R_{\pounds }\right]\right)\left(1+\mathit{fp}\right)+\left(R_{\pounds }-E\left[R_{\pounds }\right]\right)S_1$

This result is derived from the payoff on the hedged position:

$1+R_{\mathit{eh}}=\frac{E\left[P_1+\mathit{di}{v}_1\right]}{P_0{S}_0}F\left(0,1\right)+\frac{P_1+\mathit{di}{v}_1-E\left[P_1+\mathit{di}{v}_1\right]}{P_0{S}_0}{S}_1$

Manipulation produces:

$R_{\mathit{eh}}=R_{\pounds }+\mathit{fp}+e{R}_{\pounds }+\left(\mathit{fp}-e\right)E\left[R_{\pounds }\right]\cong R_{\pounds }+e+\left(\mathit{fp}-e\right)E\left[R_{\pounds }\right]=R_{\$}+\left(\mathit{fp}-e\right)E\left[R_{\pounds }\right]$

R_eh − R _$ depends on (fp − e). Hence, if forward exchange rates are unbiased predictors of future spot interest rates, then establishing the size of the hedge position by estimating the value of the asset at the end of the investment horizon will on average produce much the same result as for the stylized full hedging problem.

The full hedging concept is useful in developing certain basic properties of currency hedges, such as the free-lunch argument of Perold and Schulman (1988). However, the full (or transaction) hedge ignores the possibility that assuming a fully hedged position is consistent with the best method of determining the hedge position. Armed with this observation, it is possible to proceed to the more difficult question of determining the optimal currency hedge ratio for a portfolio containing a single foreign asset. To accomplish this, let h be the fraction of the value of the foreign asset position (P ₀) that is being hedged. With the value of the hedge being determined as h[P ₀ F(0,T)]. Table 6.16 gives the profit profile for the optimal hedge. Some presentations of the profit function (e.g., Glen and Jorion, 1993) use forward contracts where delivery takes place at t = 1, using the proceeds from the foreign asset to settle the forward position.

Table 6.16. Profit Profile for an Optimal Currency Futures Hedge

Assume: One unit of the foreign asset is being purchased; hedge position is constructed using a contract that matures at the end of the investment horizon
Date	Cash	Futures
t = 0	Convert at S 0 and buy the foreign asset at P 0	Short h P 0 of the foreign currency at F(0,T)
t = 1	Sell the asset at P 1, receive dividend of div 1 and convert back to domestic currency at S 1	Go long h P 0 at F(1,T)

Note: The profit function for this trade can be now stated as:

$\mathrm{\pi }\left(1\right)=\left(P_1+\mathit{di}{v}_1\right)S_1-P_0{S}_0+h{P}_0\left(F\left(0,T\right)-F\left(1,T\right)\right)$

Using R_0h for the return on the optimal hedged position, it follows that:

$\begin{array}{l}\frac{\mathrm{\pi }\left(1\right)}{P_0{S}_0}=R_{\mathit{oh}}=\frac{\left(P_1+\mathit{di}{v}_1\right)S_1}{P_0{S}_0}-1-h\frac{P_0△F}{P_0{S}_0}\\ =\left(1+R_{\pounds }\right)\left(1+e\right)-1-h\frac{△F}{S_0}\cong R_{\pounds }+e-h\frac{△F}{S_0}\end{array}$

From this the variance can be determined and df is defined:

$\begin{array}{l}var\left[R_{\mathit{oh}}\right]=var\left[R_{\$}\right]+h^{2}var\left[△F/S\right]-2hcov\left[R_{\$},△F/S\right]\\ \equiv var\left[R_{\$}\right]+h^{2}var\left[\mathit{df}\right]-2hcov\left[R_{\$},\mathit{df}\right]\end{array}$

With this it is now possible to determine the optimal hedge ratio using the minimum variance solution (e.g., Eaker et al., 1993). The size of the hedge position (h*) is the choice variable:

$\frac{dvar\left[R_{\mathit{oh}}\right]}{\mathit{dh}}=2hvar\left[\mathit{df}\right]-2cov\left[R_{\$},\mathit{df}\right]=0\to h^{*}=\frac{cov\left[R_{\$},\mathit{df}\right]}{var\left[\mathit{df}\right]}$

By observing that the covariance term can be further expanded as:

$R_{\$}\cong R_{\pounds }+e\to cov\left[R_{\$},\mathit{df}\right]\cong cov\left[R_{\$},\mathit{df}\right]\cong cov\left[e,\mathit{df}\right]+cov\left[R_{\pounds },\mathit{df}\right]$

With this result the minimum variance hedge ratio can be expressed:

$h^{*}\cong \frac{cov\left[e,\mathit{df}\right]}{var\left[\mathit{df}\right]}+\frac{cov\left[R_{\pounds },\mathit{df}\right]}{var\left[\mathit{df}\right]}$

Eaker et al. (1993) provide selected empirical estimates for this form of the optimal currency hedge ratio.

Closer inspection of the minimum variance hedge ratio provides some useful information. Consider the term cov[e,df]/var[df]:

$\frac{cov\left[e,\mathit{df}\right]}{var\left[\mathit{df}\right]}=\frac{cov\left[\left(S_1-S_0\right)/S_0,\left(F\left(1,T\right)-F\left(0,T\right)\right)/S_0\right]}{var\left[F\left(1,T\right)-F\left(0,T\right)/S_0\right]}$

Substituting the value of F from covered interest arbitrage reveals that this term will be close to one. If changes in the local asset return, R _£, are uncorrelated with changes in the forward exchange rate, an empirically plausible assumption, then the optimal currency hedge ratio for a single foreign asset will be close to one. Hence, the conditions under which full hedging is optimal may be empirically valid. Unfortunately, this relatively sharp result only applies to the restricted case of hedging a single foreign asset. Given this, it is natural to consider extending the analysis to allow for two assets: one domestic and one foreign (see Table 6.17).

Table 6.17. An Example of the Diversification Benefits of a Domestic/Foreign Portfolio

Question : You are considering purchasing two portfolios. One portfolio is composed 50/50 of two domestic assets each with E [R] = 0.1 and σ = 0.15 and with a 0.5 correlation between the asset returns. The other portfolio is also 50/50 and contains one of these domestic assets and a foreign asset. The foreign asset has E[R $] = 0.1 with σ £ = 0.15 and σ e = 0.03. The correlations between the foreign and domestic asset returns and between all the asset returns and the exchange rate are zero. Which portfolio is less risky?

Solution : The portfolio variance for the domestic assets is just the conventional result. To get the portfolio variance when there is a foreign asset observe that the return on a foreign asset when the return in denominated in domestic currency (R $) is given as: R $ = (1 + R £) (1 + e) − 1. Taking logs and observing ln(1 + x) is approximately equal to x when x is sufficiently small produces the result:

$\mathit{var}\left[R_{\$}\right]={{\mathrm{\sigma }}_{\$}}^2={\mathrm{\sigma }}^2+{\mathrm{\sigma }}_e^2+2{\mathrm{\sigma }}_{\pounds ,e}$

Using the variance formula for two securities and doing appropriate substitutions, it follows that for a portfolio containing a foreign asset:

$\begin{array}{l}{{\mathrm{\sigma }}_p}^2=W_d^2{\mathrm{\sigma }}_d^2+W_{\$}^2{\mathrm{\sigma }}_{\$}^2+2W_d{W}_{\$}{\mathrm{\sigma }}_{d,\$}\\ =W_d^2{\mathrm{\sigma }}_d^2+W_{\$}^2\left\{{\mathrm{\sigma }}_{\pounds }^2+{\mathrm{\sigma }}_e^2+2{\mathrm{\sigma }}_{\pounds ,e}\right\}+2\left\{W_{\$}{W}_d\left({\mathrm{\sigma }}_{\pounds ,d}+{\mathrm{\sigma }}_{e,d}\right)\right\}\end{array}$

Evaluating the relevant formulas gives for the domestic portfolio var[Rdp ] = 0.016875 (σ dp = 0.13) and for the foreign/domestic portfolio var[Rp ] = 0.011475 (σ p = 0.107121)

Due to the much lower correlation between domestic asset returns and foreign asset returns and the exchange rate (than with other domestic asset returns) including foreign assets enhances the diversification process considerably.

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Essentials of Risk Management

Richard B. Corbett , in Raising Entrepreneurial Capital (Second Edition), 2013

Financial Exposures

Financial exposures are related to the financial system and financial instruments: credit risk, commodity risk, currency exchange risk, inflation risk, and liquidity risk. The risk management strategies available for these exposures involve things ranging from policies on the granting of credit to customers, to careful selection of markets, to design of the capital structure of the entity, to the use of financial derivatives. A raw material that is used in the production process and that is traded in commodity markets can contribute to instability in the price of an entity's product. Sales to foreign customers whose currencies are subject to fluctuations can adversely affect the profitability of the enterprise. For both of these exposures, hedging opportunities exist in the financial markets to reduce risk.

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Money and Exchange Rate in the Long Run

Cristina Terra , in Principles of International Finance and Open Economy Macroeconomics, 2015

6.1.2 Assets Market

Assume that the assets from different countries are perfect substitutes, that investors are neutral to exchange rate risk and that there is perfect capital mobility. In equilibrium, the yield expected from domestic assets and foreign assets should be the same, that is, the uncovered interest rate parity must be true. Rewriting the uncovered interest rate parity from Eq. (3.13), in Chapter 3, in continuous time, we have that:

(6.2) $E\left(\frac{\mathrm{d}s(t)}{\mathrm{d}t}\right)=i(t)-i^{*}(t),$

where $E\left(\frac{\mathrm{d}s(t)}{\mathrm{d}t}\right)$ represents the expected exchange rate variation rate for period $t$ , which is the derivative of the exchange rate with respect to time. ³ When the uncovered interest rate parity is respected, there is no opportunity for arbitrage. The economic agents are indifferent between either the domestic or foreign assets and the capital flow will be exactly what is necessary to cover eventual deficits or surpluses in current account.

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explain the concept of currency risk. how can inflation and interest rates create currency risk?

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