5. Exposure Flashcards
What is FX exposure?
A measure that shows how sensitive the financial position of a firm is to changes in the exchange rate.
B=delta V / delta S
In what case does hedging add value to the firm?
hedging adds value to a firm if it helps to reduce
the volatility of cash flows
What is FX risk?
FX risk is a measure of uncertainty (like variance of S)
What is CONTRACTUAL exposure?
Contractual exposure = The FC contract size (already agreed and signed contract, delivery at future date, varies depending on S).
For LINEAR positions that are risk-free in terms of FC (there is no default risk, only FX risk), exposure corresponds to its CONTRACT SIZE.
What is OPERATIONS exposure?
Operations exposure:
- decisions are still to be taken
- FC amount is uncertain
- Relation between HC CFs and S is noisy (non-linear) and typically CONVEX in S.
What are the limitations of Conditional exposure?
- While Conditional variance decreases, the Unconditional risk is still unaffected! (Long-term volatility is not hedged). A series of hedged incomes will remain as variable as the unhedged one.
What are the 3 typical issues with Operations exposure?
1) Difficult to identify the relationship between CF and S
2) Conclusions often surprising or counter-intuitive
3) How to handle nonlinearity and noise?
Is the Operations exposure convex or concave on the graph?
Convex (U shape)
What is the sticky-price zone?
A range of S, inside which it doesn’t make sense for the firm to adjust prices (change in revenues is too small to adjust prices). Outside of the zone firm decided to adjust prices -> and it affects the sales volume.
What is the correlation between S and likely economic development?
S up - recession is more likely
S down - boom is more likely
Negative correlation between economic state and exchange rate
How do we verify the hedge of operations exposure?
Show that E(CFs) are the same in all (both) scenarios - up and down.
What will happen to E(CFs) and volatility in the General linear hedge (more than 2 scenarios)?
Hedged E(CFs) - same as without hedge Hedged volatility (CFs) - much lower! The curve on the graph will be symmetrical and convex
Estimate a regression coefficient.
Coefficient: B=delta V/delta S = slope of the exposure line.
What are the steps to implement a strategy when there are more than 2 cases?
Dumas’ regression approach:
Step 1: Come up with a table containing a column of representative possible ST ’s, a column showing their probabilities, and a column showing the expected CF in HC for each scenario
Step 2: Decompose the (HC) CF’s into a part perfectly correlated with S˜ and a part uncorrelated with S˜t
This is done via regression across possible time-T scenarios:
V˜ = A + B*S˜ + ˜e = A + ˜e
Step 3: Sell forward FC B (i.e. buy –B if B < 0)
Should we sell of buy FWD if exposure of our asset is NEGATIVE?
Negative exposure - BUY FWD
How do we calculate CFs (payoff) of the FWD hedge?
CF=B* (F-S)
