The Impact of Currency Movements on Asset Value Correlations
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.
|Date of creation:||02 Oct 2013|
|Date of revision:|
|Contact details of provider:|| Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund,Sweden|
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- Merton, Robert C., 1973.
"On the pricing of corporate debt: the risk structure of interest rates,"
684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- 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 449-70, May.
- Dirk Tasche, 2007. "Incorporating exchange rate risk into PDs and asset correlations," Papers 0712.3363, arXiv.org.
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