Paul McCormack is a U.S. investor interested in valuing a Japanese security. Which of the following regression equations would be useful to McCormack in assessing the currency exposure of the Japanese security to changes in the dollar/yen exchange rate? A) Local currency return = á + â (world market return). B) Domestic currency return = á + â (world market return). C) Domestic currency return = á + â (exchange rate movement). Your answer: C was correct! To assess currency exposure, regress domestic currency returns against exchange rate movements [Domestic currency return = á + â (exchange rate movement)]. In this formulation, â would be an estimate of the currency exposure and would likely be called ã if used in the international capital asset pricing model. I have reread Schweser’s explanation 4 times and still do not get what they are talking about! Any suggesions?
When you want to find your currency exposure, what you are doing is trying to find out how a company’s returns change with the exchange rate environment. If you recall from the economics section, when the real exchange rate change causes the local currency to depreciate, its exports will be in higher demand causing returns to be possibly higher (if the company is an exporter). We want to see these effects and by regressing the security in question’s returns over exchange rate movements, we can see eactly that. The slope coefficient gives us the ‘sensitivity’ in terms of the local currency