Question

You are a U.S. investor who is considering investments in the Australian stock market, but you worry about currency risk. You run a regression of the returns on the Australian stock index (in A$) on movements in the Australian dollar exchange rate (U.S.$ per A$) and find a slope of -0.5.

a. What is your currency exposure if you invest in a diversified portfolio of Australian stocks?

b. You invest $10 million in the diversified portfolio, but you fear that the Australian dollar will depreciate by 10 percent relative to the U.S. dollar. How much do you expect to lose because of the currency movement?

Answer 1

(A) Currency exposure is very significant while investing in other countries. An investor must exercise due diligence of currency movement as it may erode its capital gains.

In the given case, the US investor is considering investing in the Australian Stock market and is worried about the currency risk. In regression, when you have a positive slope you have a positive correlation between the variables and vice versa. Therefore, under the given circumstance, if you invest in a diversified portfolio of Australian stocks, the returns on investment would be wiped by a negative correlation between the two currency variables.

(B) $10,000,000 invested in Australian stocks. Suppose the exchange rate is 1 USD = 100 AUD. Value in Australian currency= AUD 1,000,000,000. Now Suppose an ROI of 10%. Value at the end of period = 1,100,000,000. Now if AUD depreciates by 10%. ie. 1 USD = 110 AUD. The conversion value in USD on this new exchange rate would be $10,000,000.

Through this example, you can see the returns on the investment has been wiped off due to the depreciation in the foreign currency. So, the investor must observe the currency movement carefully and must be aware of currency risk while investing in any country's market.