I mean in this case you could have economic risk - the bond changes in value in LOCAL currency due to a change in interest rates (this is a little stretched) transaction risk - the cupon will change in value in DOMESTIC currency because of exchange rate risk translation risk - reporting on the balance sheet in DOMESTIC currency will create a loss of value because of interest rates
Think of economic risk this way: it’s the risk you’re exposed to that you didn’t hedge when you hedged your principal. For example, if you hedge the currency on the principal amount of a stock you purchase, the currency exposure you have on the gains or losses is economic risk.
Thanks everyone…i found the following explenations from a Schweser exam and thought they were helpfull, just thought i would share. Transaction exposure is from transactions already entered into and the amount to hedge is thus known. Transaction exposures are the most commonly hedged exposures of a firm. Economic risk, the relationship between changing exchange rates and asset values, is not contractual and the amount to hedge is thus less certain, making it harder to hedge. Translation risk refers to the effect of exchange rate changes on the income statement and balance sheet and is often not hedged.
This sh!t is bananas, B-A-N-A-N-A-S. You can thank Gwen Stefani for that one.
AFJ, most of the confusing comes from these terms being defined two different ways in two different readings.
I think we should kill this thread
So from what has been said, I’m hearing that: Transaction risk: Very hedgable, represent discrete events such as cash flows. Translation risk: Less hedgable, represent currency driven value fluctuations between purchase and exit for investments being held on balance sheet. Economic risk: Risk to underlying investment from currency shifts. Such as a foreign firm’s real demand falling in response to strengthening currency.
I would agree with Black Swan 100%
I second that.
florinpop Wrote: ------------------------------------------------------- > I would agree with Black Swan 100% In regards to bananas or translation?
both BANANAS
Agree with bananas. 100%
If transaction risk is the most commonly hedged, but the principal is the most commonly hedged component which refers to translation risk, how does that make sense? Translation risk according to pg 217 of schweser book 4 is the ht=1 in the minimum variance hedge. Then economic risk is the covariance of Rinlocalcurrency and Rcurrency divided by vhe variance of currency returns. they don’t even mention transaction risk or financial statements in the whole section…
Translation risk is defined differently in that reading vs the very next one.
Sorry to add eventually more confusion here… There are 2 points of view: 1) as a manager of the company and 2) as an investor in a company’s bond. 1) as a manager, when I sign a deal with an other company, I’m interested in receiving / paying the cash flows that I envisaged when I signed the contracts. So I’m interested in protecting the cash flows and ultimately the result of the deal --> This is a TRANSACTION risk. I’m going to set up hedges to protect my cash flows. 2) as a investor in a company’s bond it is a little bit more difficult. Depending on the business of the company, it could make more or less business depending on various exchange rates. They have an ECONOMIC risk here. Say you the company is in UK and export local products. If the GBP depreciates v.s. Euro, then this company is likely to do more business (it may take a few months to see the real impact). Let say it does, then the economic situation of the company is improving, normally. Consequences: the spread on the bond is going down -> the price of the bond is going up. So there is a relation between the exchange rate GBP / Euro and the spread of the bond. As an investor, I may want to hedge this component of risk. This relation is captured by the hE. Now, as an investor, my bond is in GBP, so I may want to hedge also the principal hence the hT (which equals 1). I think it works even better as an equity investor. My hedge should not only be to hedge my asset but to hedge the changes in local currency of my asset as a result of changes in FX rates. In Level 2, last year, there was a similar concept. I cannot remember it fully but there was a ratio and depending on which side of the fence you were, you had to add 1 or not. Remember something like that? This is the same concept here. Now, the TRANLASTION risk. Completely different, indeed. This is the risk that the BS converted in an other currency is going to change as the consequence of change in FX rates. That is a risk for a mother company having different subsidiaries in different places. Remember that we saw quite un-funny formulas to “translate” a BS last year (or was it already for Level 1) and there are different approaches (thanks God, I already forgot these things - I have more space left for Level III then)… No-one would hedge the translation risk, unless the mother company sees the subsidiary as an investment, and then wants to hedge it… MH