Domestic and local currency exposure

I always have trouble with idenifying from the question which is Y and which is Y(LC). Can anyone explain with an example in simple term please? Theres a question in mock 2011 q23 morning that I seem not to comprehend their explanation. The way I thought is if GBP appreciate 2%, usd depreciate same level, so the net effect should be zero. How can the investor can still earn 2% in USD term?

Let’s first see it from the perspective of a domestic investor who invests in a foreign country.

domestic return (Rdc) = local/foreign return (Rlc) + appreciation in local/foreign currency (delta S)

So your domestic return can vary based changes to these two underlying components [Rlc] and [delta S]. Eg. US investor invests in a UK stock. Its dollar return will be equals the return of the UK stock plus appreciation of UK currency against USD (or less depreciation for that matter).

However the performance of the stock is also dependent on the local currency changes depending on the nature of the business (export, import, cyclical, etc). Let’s say that the expected return of UK stock is 10%. But due to UK appreciating by 5%, the stock return is reduced to 9%. This means that an appreciation of 5% in UK currency results in 1% decrease in stock returns => local currency exposure = -1/5 = -0.2.

If you piece this together. This means it will translate to -0.2 + 1 = 0.8 change in USD returns for the domestic investor per unit % change in UK currency. Note that the “1” w.r.t local currency exposure means your USD returns also increase by the amount of local currency appreciation (eg. if UK appreciate by 5% your dollar equivalent return is also 5%).

Thus, domestic currency exposure = 1 + local currency exposure (based on per unit change in exchange rates)

Hmm… this one is very tricky and i also struggled once.

Think of it this way. If you are required to calculate for e.g., JPY exposure for an US investor, always remember JPY is the LOCAL currency and USD is the DOMESTIC currency.

If JPY strengthens, value of your asset denominated in JPY (i.e. japanese stock) goes up by equal percentage. Think correlation of 1.

However, if JPY strengthens the stock’s price (in JPY terms, and not in USD) may go up-importer ( Y=positive correlation, value between 0 and 1) or may go down- exporter (Y= negative correlation, value between -1 and 0).

to use in the ICAPM, you have to simply add these two, i.e Y(LC) plus 1. Y(LC) can range anywhere between -1 to +1. Hence ‘Y’ always equals a value between +1 to +2.

Hope it helped.