PM - Domestic Currency Exposure

CFA Level II
#1

Hi, Can someone explain WHY Domestic Currency (DC) exposure equals Local Currency (LC) exposure + 1 DC = LC +1

#2

it magnifies the returns, i.e. positive exposure (like a foreign bond) you get appreciation/deprecation and returns from fx gain/loss

#3

hmmm…anyone else have another explanation?

#4

an investor has exposure to currency, if an investor invests in his home currency exposure is 1 since LC = 0, so when u use the ICAPM you need figure out the return in your home currency via ur exposure to the foreign

#5

thanks but, I think I need a more detailed explanation please…

#6

It’s easiest to think of this in terms of an example: If you’re an investor from Europe that goes long in a US company, you are 100% exposed to USD. Now, let’s say the US comapny is an exporter who’s value would decrease if the USD appreciates. You, as an investor in this company have exposure to the USD, AND exposure to the company who’s value is inversely related to USD. Thus, the formula: (Lamda)DC = (Lamda)LC + 1 Where: (Lamda)DC = Total currency sensitivity (Lamda)LC = Company’s sensitivity to currency fluctuations 1 = The 100% sensitivity of being invested in the given currency. Hope that helps…

#7

hi thanks…but, the +1 still isn’t perfectly clear…

#8

+1 = 100 % of your position is exposed to FX risk due to the fact that you invested money in another currency (your return will be influenced by FX rate movement, if FX rate moves by 1 % your return in your currency moves by 1 % point) the LC exposure says that on top of this FX risk, the local investment is sensitive to FX rate movement because the business itself is sensitive to FX rate moves (typically if you invest to shares of an exporter or importer).

#9

Let think it in RISK concept: e.g. you are from US. 1. the left of the equation is DC, which means the risk if you invest in your own country - you invest in US and you have to bear the risk that associates your investment return. 2. the right of it should be considered as you invest in UK: how should you get your investment return in UK? - a. you must consider the EUR return (that would be the same as point 1 if you are a UK resident - b. you must consider even if you have gain in EUR, you have to get it back in your USD account. this is a process of changing currency from EUR to USD So the equation on the right side should be: (a+b)/exchange rate; we don care the a and b is a gain or loss since in part b, the changing from EUR to USD is just the exchange rate(you can think the sensitivity is 1), so we can reduce the fraction to get (a/exchange rate) +1, which in fact is LC+1 more in theory, the investment return should be the same whether you invest in US or UK. therefore they bear the same level of risk. DC=LC+1

#10

Thanks guys…understand now.

#11

I think the way Schweser explains it, it’s quite easy. You buy a stock in Japan - assuming that the company is an exporter, then the stock of the Japanese firm will rise when the currency depreciates and your investment in the Japanese stock, measured in JPY returns, will go up. So in this case, your foreign currency exposure is negative - a strong JPY will lessen your JPY returns, a weaker JPY will increase your JPY returns. It will be the other way around for a Japanese importer. And then you obviously ahve to account for the exchange rate impact of the change in the currency. So if the JPY depreciates against the USD, the value of the Japanese exporters stock will increase (whcih is a plus), but the value of the now higher JPY return on the investment declines by the rate of depreciation of the JPY. This impact is 1:1, so that’s who you get the above equation.