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The Impact of Currency Movements on Asset Value Correlations

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Abstract

This paper looks at the asset correlation bias resulting from firms’ assets and liabilities being denominated in different currencies. It focuses on the time-variation in the bias and on the dependency of the bias on currency movements. Both the volatility of the exchange rate and the correlations between the asset values and the exchange rate affect the bias and we find the sensitivity of the bias to the former to be greatest. Despite this, and as a result of the wide fluctuations of the asset value - exchange rate correlations over the last ten to fifteen years, the asset value - exchange rate correlation’s net effect on the bias is more significant, economically. Overall, we find that the asset correlation bias for the average pair of firms in the Dow Jones Industrial Average index is significant for the better part of the 2000-2013 time period. The bias fluctuates widely, however, and it has turned negative for shorter periods. The policy implication of the paper is that by ignoring the exchange rate component when computing portfolio credit risk one may materially underestimate the actual risk. Particularly at times of frequent and significant exchange rate movements.

Suggested Citation

  • Byström, Hans, 2013. "The Impact of Currency Movements on Asset Value Correlations," Working Papers 2013:33, Lund University, Department of Economics.
  • Handle: RePEc:hhs:lunewp:2013_033
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    File URL: http://project.nek.lu.se/publications/workpap/papers/WP13_33.pdf
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    References listed on IDEAS

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    1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    2. Dirk Tasche, 2007. "Incorporating exchange rate risk into PDs and asset correlations," Papers 0712.3363, arXiv.org.
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    Cited by:

    1. Byström, Hans, 2016. "The Currency Composition of Firms' Balance Sheets and its Effect on Asset Value Correlations and Capital Requirements," Working Papers 2016:1, Lund University, Department of Economics.

    More about this item

    Keywords

    asset correlation; time-variation; sensitivity; exchange rate; currency risk;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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