Financial news

Exchange rate risk is the uncertainty of returns to an investor who acquires securities denominated in a currency different from his or her own. The likelihood of incurring this risk is becoming greater as investors buy and sell assets around the world, as opposed to only assets within their own countries. A U.S. investor who buys Japanese stock denominated in yen must consider not only the uncertainty of the return in yen but also any change in the exchange value of the yen relative to the U.S. dollar. That is, in addition to the foreign firm’s business and financial risk and the security’s liquidity risk, the investor must consider the additional uncertainty of the return on this Japanese stock when it is converted from yen to U.S. dollars.
As an example of exchange rate risk, assume that you buy 100 shares of Mitsubishi Electric at 1,050 yen when the exchange rate is 115 yen to the dollar. The dollar cost of this investment would be about $9.13 per share (1,050/115). A year later you sell the 100 shares at 1,200 yen when the exchange rate is 130 yen to the dollar. When you calculate the HPY in yen, you find the stock has increased in value by about 14 percent (1,200/1,050), but this is the HPY for a Japanese investor. A U.S. investor receives a much lower rate of return, because during this period the yen has weakened relative to the dollar by about 13 percent (that is, it requires more yen to buy a dollar—130 versus 115). At the new exchange rate, the stock is worth $9.23 per share (1,200/130). Therefore, the return to you as a U.S. investor would be only about 1 percent ($9.23/$9.13) versus 14 percent for the Japanese investor. The difference in return for the Japanese investor and U.S. investor is caused by the decline in the value of the yen relative to the dollar. Clearly, the exchange rate could have gone in the other direction, the dollar weakening against the yen. In this case, as a U.S. investor, you would have experienced the 14 percent return measured in yen, as well as a gain from the exchange rate change.
The more volatile the exchange rate between two countries, the less certain you would be regarding the exchange rate, the greater the exchange rate risk, and the larger the exchange rate risk premium you would require.
There can also be exchange rate risk for a U.S. firm that is extensively multinational in terms of sales and components (costs). In this case, the firm’s foreign earnings can be affected by changes in the exchange rate. As will be discussed, this risk can generally be hedged at a cost.

In this section, we explore how to price and value three types o f equity swaps: ( I ) a swap to pay a fixed rate and receive the return on the equity, (2) a swap to pay a floating rate and receive the return on the equity, and ( 3 )a swap to pay the return on one equity and receive the return on another.
To price or value an equity swap, we must determine a combination of stock and bonds that replicates the cash flows on the swap. As we saw with interest rate and currency swaps, such a replication is not difficult to create. W e issue a bond and sell a bond, with one being a fixed-rate bond and the other being a floating-rate bond. I f we are dealing with a currency swap, we require that one o f the bonds be denominated in one currency and the other be denominated in the other currency. With an equity swap, it would appear that a replicating strategy would involve issuing a bond and buying the stock or vice versa, but this is not exactly how to replicate an equity swap. Remember that in an equity swap, we receive cash payments representing the return on the stock, and that is somewhat different from payments based on the price.
Pricing a Swap to Pay a Fixed Rate and Receive the Return on the Equity: By example, we will demonstrate how to price an n-payment m-day rate swap to pay a fixed rate and receive the return on equity. Suppose the notional principal is $1, the swap involves annual settlements and lasts for two years (n = 2),and the returns on the stock for each o f the two years are 10 percent for the first year and 15 percent for the second year. The equity payment on the swap would be $0.10 the first year and $0.15 the second. I f ,    however, we purchased the stock instead o f doing the equity swap, we would have to sell the stock at the end o f the first year or we would not generate any cash. Suppose at the end o f the first year, the stock is at $1.10. W e sell the stock, withdraw $0.10, and reinvest $1.OO in the stock. At the end o f the second year the stock would be at $1.15. W e then \ell the stock, taking cash of $0.15. But we have $1.OO left over. To get rid of,or offset,this cash flow, suppose that when we purchased the stock we borrowed the present value of $1.00 for two years. Then two years later, we would pay back $1.00 on that loan. This procedure would offset the $1.00 in cash we have from the stock. The fixed payments on the swap can be easily replicated. I f the fixed payment is denoted as FS(O,n,m),we simply borrow the present value o f FS(O,n,m) for one year and also borrow the present value of FS(O,n,m)for two years. When we pay those loans back, we will have replicated the fixed payments on the swap.Equity