I can’t seem to get my arms around this. Is there an easy way to understand this stuff?
I’m with you. This is what I’ve figured out for myself: 1. In optimal hedging ratio, hT refers to Translation Risk. 2. In a different section, where there are three currency risks (translation, transaction, and econ), transaction risk is addressed through the use of derivatives. That is, hedging. Anyone else?
translation - risk of TRANSLATING a foreign asset value in your own currency transaction - risk when already entered in a TRANSACTION - related to foreign CASH FLOWS that you need to pay or receive economic - risk of changing the ECONOMICS of a foreign relationship- decreased economic trade, revenues etc
Example - a company in US has a export sales forecast of NZ$100m. 1) If actual sales drop to NZ$50m - that’s economic risk. Impact is lower sales revenue in PL 2) Now assuming sales credit of 2 months, and US$ appreciate relative to NZ$ by the end of 1st month, NZ$50m will be worth less in US$ term - that is translation risk. Impact is unrealised loss (or unrealised gain if US depreciate) in PL 3) Subsequently at point of payment at the end of 2nd month, US$ depreciate against NZ$ - that is transaction risk. Impact is REALISED exch gain (or realised loss if US$ appreciate against NZ$) in PL.
which one is hedged with currenty forwards usually? transaction?
usually you hedge cash flows.
Doesn’t the hedge ratio also take economic risk into account? Meaning the optimal hedge will offset transaction and economic risk (if constructed properly)? That is the whole Hedge ratio=Ht+He…thingy.
mwvt9, yes, HT is =1 (i.e. principal) and He is that nasty formula which i studied yesterday and already forgot.
Somebody save me, still very confused about the difference between Transaction / Translation risk. I’ve seen this on several practice exams and am still uncertian…
AFJunkie Wrote: ------------------------------------------------------- > Somebody save me, still very confused about the > difference between Transaction / Translation risk. > I’ve seen this on several practice exams and am > still uncertian… florinpop explained it really well. Let’s say you have a portfolio of european stocks that are worth 2 billion euros. your translation risk is 2 billion euros. now let’s say you need to pay 1 million euros in fees in 2 weeks. your transaction risk is 1 million euros. Does that help?
Oaky i think i understand it a little better now. I had issues distinguishing between the two. let me try this with a different example to see if I got it… I am a US investor and have a 10m Euro denominated bond maturing in 5 years, and pays a 10% coupon semi-annually. So converting the coupon payment into USD every 6 months would be transaction risk, but converting the principle upon maturity of the bond would be translation risk?
No I don’t think. Translation risk would be the risk of the VALUE of the bond varying on your balance sheet just due to exchange rates (kind of like accounting risk). Transaction risk would be the risk of varying amounts for both coupon and principal when exchanged by into the domestic currency.
mwvt9 I think you are wrong and junkie is right what you are saying would be economic risk
AFJunkie Wrote: ------------------------------------------------------- > Oaky i think i understand it a little better now. > I had issues distinguishing between the two. let > me try this with a different example to see if I > got it… > > I am a US investor and have a 10m Euro denominated > bond maturing in 5 years, and pays a 10% coupon > semi-annually. > > So converting the coupon payment into USD every 6 > months would be transaction risk, but converting > the principle upon maturity of the bond would be > translation risk? True the bond is your investment on the balance sheet – which faces translation risk
florinpop Wrote: ------------------------------------------------------- > mwvt9 I think you are wrong and junkie is right > > what you are saying would be economic risk That is not how I understand it. Economic risk is the risk of business not taking place at all due to changes in forex rates. Like for importer/exporter.
I though the translation risk of the investment on the balance sheet becomes transaction risk when the principal is converted back to domestic.
one good thing to note----you aren’t as likely to hedge currency risk if for example, the firm’s stock you are buying is a foreign exporter. since if currency drops, they do better. CFAI might have something tricky like htis on the exam on “which firm should hedge” type question. i screwed this up on an exam recently.
AFJunkie Wrote: ------------------------------------------------------- > Oaky i think i understand it a little better now. > I had issues distinguishing between the two. let > me try this with a different example to see if I > got it… > > I am a US investor and have a 10m Euro denominated > bond maturing in 5 years, and pays a 10% coupon > semi-annually. > > So converting the coupon payment into USD every 6 > months would be transaction risk, but converting > the principle upon maturity of the bond would be > translation risk? That’s not quite right or maybe I misunderstand your example. Let’s say the value of the bond is 8 million euros (face value is 10 million, coupon is 10%). Translation risk is the risk you are exposed assuming there are no changes in the value of the asset in local currency. If tomorrow, the value of the bond is going to be 8 million euros but euros go down by 1%, you lose money. Now, let’s consider transaction risk. You are correct that if you expect to recieve 500,000 euros in coupon payments in 3 months, you face a transaction risk. The same probably applies to principle. I was thinking of transaction risk in terms of cash flows that firms face such as purchase or sale of something but I guess it can also apply to your example.
I missread your statement mwt9 I thought you said that the bond would change in value in local currency because of a change in exchange rates
agree with maratikus 100%