Analyzing Market Risks: Three Key Exposures
Corporates analyze market risks (in particular FX risks) in terms of three key exposures: transaction exposures, economic exposures, and translation exposures. Let us discuss each of these exposures.
Transaction exposures arise because of adverse changes in prices. For example, a US based company buying goods from a Japanese company will incur transaction risk because it is exposed to the exchange rate fluctuation (specifically rising yen).
The first step in analyzing the risk of any transaction is to decompose the risk of a transaction into component risks. Even a single transaction can have multiple component risks. For example, a USD-based investment manager with a DEM-denominated convertible bond position has the following component risks:
FX risk: Exposure to DEM depreciating vs. USD @ Interest rate risk: Exposure to rising rates, which make bond prices fall
Spread risk: Exposure to rising credit spreads (that is, deteriorating credit quality of issuer), which makes bond prices fall
Volatility risk: Exposure to falling equity volatility, which reduces the value of the equity conversion option
Equity risk: Exposure to falling stock price of the underlying company
These individual component risks can then be aggregated across a portfolio of instruments to highlight common risk factors.
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