Not sure why Im having a hard time with this because it seems like it should be very simple but can someone explain domestic currency exposure in very basic terms? Kind of confused by how they explain positive and negative exposure in the government intervention and free market theories
Let me start with this formula: Domestic Currency Exposure = 1 + Local Currency Exposure Now, i will attempt to explain. Domestic Currency Exposure: If you have an asset denominated in a Foreign Currency, then you face Exchange Rate Risk. Correct? This sensitivity to exchange rates, referred to as Domestic Currency Exposure has 2 components: 1. First one is quite straight forward. If foreign currency, in which you hold that asset depreciates, you have a direct loss by that amount. And if that Foreign Currency appreciates, you have a direct gain. So, the first part of your exposure is DIRECTLY related to Exchange Rate movements. (so, this component of sensitivity is taken as 1) 2. Second component of sensitivity is based on, how THAT particular foreign asset behaves when its local currency appreciates or depreciates. This component is referred to as the Local Currency Exposure of that Asset. For example, if that asset gains value, when its local currency appreciates, then there is a POSITIVE correlation between value of that Asset and its Local Currency. This means there is a POSITIVE Local Currency Exposure. But, if that Asset gains value, when its Local Currency Depreciates, then there is a NEGATIVE correlation between Value of that Asset and Exchange Rates. This is referred to as NEGATIVE Local Currency Exposure. Now, in Govt. Intervention Model, Local Currency Appreciation is explained to cause HIGHER Bond Prices, thus, there is a Positive Correlation between them and thus a POSITIVE Local Currency Exposure for Bonds Asset Class. Whereas, Free Market Theory model explains LOWER Bond Prices with Local Currency Appreciation, thus a NEGATIVE correlation between them and a NEGATIVE Local Currency exposure to a foreigner who holds those bonds. Hope it helps.
rus1bus, that helped a lot, thank you and good luck.