Chapter 40.docx

2 Pages

Management Info. Systems
Course Code
MIS 4500
Pourang Irani

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Chapter 40: Currency Risk Management  Minimum-Variance Hedge Ratio: used when foreign currency value of foreign investment reacts systematically to an exchange rate movement o R  R hR H F * * cov R ,R F o optimal hedge ratio (regression hedge ratio): h   2 ; also can be * * F estimated as R = a + h R F error term o Translation risk: from translation of value of asset from foreign currency to domestic currency; hedge ratio for translation risk is 1  RH R  s 1h : minimizing the first term comes from an h of 1 o Economic Risk: when foreign currency value of foreign investment reacts systematically to an exchange rate movement (say when country raises interest rates to fight currency depreciation)  hedge ratio estimated by: cov R,s   2 s o Hedging Total Currency Risk: both translation risk and economic risk  Influence of the Basis: futures and spot exchange rates differ by a basis o Basis risk: basis equals interest rate differential o Implementing hedging strategies:  1. short-term Ks, rolled over at maturity  2. Ks w/ matching maturity  3. long-term Ks w/ maturity extending beyond hedging period o Hedging Multiple Currencies:  try to find Ks on other currencies that are closely correlated w/ (nonactively traded) investment currencies  optimization techniques can be used to construct hedge w/ futures Ks in only a few currencies  practice:  select independent major currencies w/ futures Ks available  run multiple regression of domestic currency returns of portfolio on futures returns of selected currencies  use regression coefficients as hedge ratios Insuring and Hedging w/ Options: as insurance or as hedging by accounting for relationship b/w premium and underlying exchange rate  Insuring w/ Options: o Net dollar profit on put = V0K S VtP 0 0 when K>S; t V 0 0 other
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