In order to calculate exposures to exchange rate accurately, the difference between the concepts of denomination currency and exposure currency must be clearly understood. As afirst rough definition, the denomination currency of a product or service globally, in a particular country or economic environment can be described as the currency in which receipts and payments for these products or services are carried out globally, in a particular country or economic environment. However, the exposure currency of the same product or service is the “natural” currency for their receipts and payments.
A better understanding of the difference between denomination cur- rency and exposure currency requires further investigation. The laws of most countries state that the currency is the one issued by its central bank and that this is the only payment method accepted in transactions within that country. Therefore, the denomination currency of the goods and services which are exchanged in a given country is the currency issued by the central bank of this country. In the USA the denomination currency is the US dollar, in the eurozone the EU denomination currency is the euro, in the UK it is the pound sterling and so on.
In order to understand exactly what the exposure currency is, imagine a product that is not produced in a given country and is therefore imported in its entirety. In this case, the denomination currency is a currency issued by the central bank of the country importing the product. However, the foreign supplier of the product usually requires payment to be made in their currency and not in the currency of that country and, therefore, if the price of the product in the foreign currency is stable, the price of the product expressed in domestic currencyfluctuates with the exchange rate.
Therefore, in this case the exposure currency (“natural” currency) of this asset is the currency of the foreign country where it is produced.
More specifically, suppose there is a product that is produced and consumed almost exclusively in the USA. In the USA the price of this product is denominated in dollars. Assume also that the price of this product in the USA is very stable and the only variation comes from the
annual inflation update. Specifically, assume that the price of this product in the USA was $20 from January 1990 to October 1997, $22 from November 1997 to July 2005 and $24 from August 2005 to June 2012.
Finally, suppose that a country in the eurozone, such as Spain, chose to import this asset.
As already indicated, in Spain the denomination currency of this product is the euro. However, the supplier of the product in the United States requires the exported product to be paid for in dollars at the same rate that it has in the United States and, consequently, the price of the product expressed in euros fluctuates with changes in the €/$
exchange rate.
As shown in Fig.6.4, the€/$ exchange rate is very volatile; therefore, the retailers of the product in Spain will have to change its price in euros with some frequency in order to ensure that they are able to pay the US provider in dollars without much exchange rate risk. For this reason, as seen in Figs.6.5 and 6.6, the price of the product in the United States
Fig. 6.4 Exchange rate €/$ (Data source: Bloomberg; Author’s own composition)
denominated in dollars is stable, that is, does not fluctuate with the exchange rate €/$, while its price in Spain, which is denominated in euros, is not stable but rather fluctuates in much the same way as the exchange rate€/$.
Consequently, the consumer of this product in Spain, despite paying in euros (the denomination currency), is exposed to the€/$ exchange rate. In Spain the denomination currency of the imported product is the euro and the exposure currency is the dollar, which is the natural currency for payments of this product.
Following the logic of the example, it can be concluded that the exposure currency of a product is one in which the price of the product does not vary in response to variations in the exchange rate. In the above example, when the product was being produced and consumed entirely in the USA, its price in dollars did not vary in response to changes in the $/€
exchange rate, while the price of the product in euros is very sensitive and varies widely when there are changes in the $/€ exchange rate.
25 1.4
1.2 1.0 0.8 0.6 0.4 0.2 0.0 24
23 22 21 20 19 18
Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Exchange Rate €/$
$ €/$
Product Price Dollers
Fig. 6.5 Comparison of€/$ exchange rate and product price in $ (Data source:
Bloomberg; Author’s own composition)
6.2.1 Estimation of Exposure Currency
The example above is a simple case in which it was assumed that there was only one exposure currency and the prices were stable in this currency.
But these two assumptions are not always realised in practice, especially in the case of goods that are consumed in many parts of the world where there are restrictions on their production and/or transportation. For example, hydrocarbons are produced and consumed worldwide but can- not be produced according to the desired amount. Instead, the quantity of the product depends on the amount discovered and its transport costs, especially in cases such as natural gas. Similarly, agricultural products are produced and consumed worldwide and their production depends on external factors such as weather, well-established production cycles and transport costs.
For this reason, in this section a technique that can be used to determine, at least approximately, the exposure currency or currencies of a particular product will be analysed. This explanation will be based on a real example to better establish the relevant concepts. It is well known that
30 25 20 15 10 5 0
Product Price in Euros Exchange Rate €/$
1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0
Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 €/$
€
Fig. 6.6 Comparison of€/$ exchange rate and product price in€(Data source:
Bloomberg; Author’s own composition)
the denomination currency of oil in almost all parts of the world is the US dollar since in all oil markets, regardless of where they are located, it is priced in dollars. The question then may be asked: is the exposure currency in oil prices the dollar?
It is not easy to answer this question because oil is produced and consumed worldwide. Its price varies depending on the change in established reserves, the discovery of new deposits, the agreements reached by the OPEC countries, the variation in the country risk of the producer countries, the economic cycle of the consumer countries and so on. However, to answer this question, the logic remains the same and the exposure currency will be the one in which the price does not vary with changes in the exchange rate.
As in the previous example, a graphical analysis can be useful here because it shows the price variations in a currency over time and the exchange rate variations over time. In this way, the relationship between the two can be studied. Figs.6.7and6.8show the evolution of the price of oil in dollars per barrel ($/bbl) and€/bbl compared to the exchange rate.
As can be seen in the graphs, in the years 2000–2003 (solid circle) there was a less noticeable increase in the oil price in $/bbl than in€/bbl, in a context of dollar appreciation (the scale can be misleading, but in€/bbl the price went from being under€20/bbl to over€40/bbl, while in $/bbl
160 1.2
1.1
1.0
0.9
0.8
0.7
0.6 Crude Oil Price in $/bbl
Exchange Rate €/$
140 120 100 80 60 40 20 0
$/bbl Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 €/$
Fig. 6.7 Comparison of crude oil price in $/bbl and€/$ exchange rate (Data source: Bloomberg; Author’s own composition)
the price had a similar level initially but barely reached $30/bbl). Follow- ing the logic of the previous example, it seems that at that time the exposure currency was the dollar. However, in the years 2009–2011 (dotted circle) the price of crude oil increased in both currencies, with a far greater increase in dollars coinciding with an appreciation of the euro against the dollar. In this case, it appears that the exposure currency of crude oil at least at this time was the euro, since there were fewer variations when there were changes in the exchange rate.
Repeating this graph with the oil price in $/bbl and Argentine pesos/
bbl, as seen in Figs.6.9and6.10, the conclusion is quite different because while the price of crude oil in $/bbl has no connection with the exchange rate $/Argentine peso, oil prices in Argentine pesos/bbl are closely related to the exchange rate $/Argentine peso. Specifically, in 2002, when the dollar suddenly became worth three Argentine pesos as opposed to one previously, the oil price in Argentine pesos/bbl tripled while in $/bbl it remained unchanged.
From this graphical analysis, it can be concluded that the dollar and the euro appear to be oil exposure currencies while the Argentine peso does not. Deeper statistical studies, which are beyond the scope of this book, show that there is not just one exposure currency of crude oil but a
160 1.2
1.1 1.0 0.9 0.8 0.7 0.6 Crude Oil Price in €/Bbl
Exchange Rate €/$
140 120 100 80 60 40 20 0
€/bbl Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 €/$
Fig. 6.8 Comparison of crude oil price in€/bbl and€/$ exchange rate (Data source: Bloomberg; Author’s own composition)
500
Exchange Rate Argentine pesos/$
Crude Oil Price in $/Bbl 450
400 350 300 250
150 100 50
Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 $/Peso Arg
$/bbl
0.9 1.4 1.9 2.4 2.9 3.4 3.9 4.9 4.4
0 200
Crude Oil Price in $/Bbl
Exchange Rate Argentine Pesos/$
Fig. 6.9 Comparison of crude oil price in $/bbl and Argentine pesos/$
exchange rate (Data source: Bloomberg; Author’s own composition)
500 450 400 350 300 250
150 100 50
Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 $/Peso Arg
Peso Arg/bbl
0.6 1.1 1.6 2.1 2.6 3.1 3.6 4.6 4.1
0 200
Exchange Rate Argentine Pesos/$
Crude Oil Price in Argentine Pesos/Bbl
Fig. 6.10 Comparison of crude oil price in Argentine pesos/bbl and Argentine pesos/$ exchange rate (Data source: Bloomberg; Author’s own composition)
combination of several, of which the dollar and the euro stand out, the dollar weighted at around 60 % and the euro weighted at around 40 %.