Apply the Value-at-Risk (VaR) method to estimate transaction exposure to exchange rate movements and answer the following questions. Assume that the monthly percentage changes of each currency and the monthly percentage changes of the portfolio are normally distributed. The maximum 1-month loss of the currency portfolio is determined by the lower boundary (the left tail) of the probability distribution which is about 1.65 standard deviations away from the expected percentage change in the currency portfolio. The home country is the U.S. and therefore the home currency is the U.S. dollar. Pfizer Corporation, a U.S. exporting firm, expects to receive payments denominated in both euro () and British pound () in one month. Based on today's spot rates, the dollar value of the funds to be received next month is estimated at $500,000 for the euro and $500,000 for the pound. The company is exposed to a currency portfolio consisting of only the euro and the pound. The company wants to determine the maximum expected 1-month loss due to a potential decline in the value of these currencies (downside risk), based on a 95% percent confidence level. Based on the data for the last 60 months, it estimates the standard deviation of monthly percentage changes to be 7 percent for the euro and 8 percent for the pound. The correlation coefficient (CORR or p) between the euro and the pound is 0.30. (Note: Make sure that all the signs (+/-) of your answers are accurate.) (a) Assume that the expected percentage change for the euro during the next month is -2%. (1) What is the maximum 1-month loss of euro in percentage? (3 marks) (2) Suppose the spot rate of the euro (S) is $1.20/euro. Based on the maximum 1-month loss that you obtain from part (1) above, what is the euro value? That is, if this maximum one- day loss occurs, what will the euro's value decline to? Answer this question using the direct quote of exchange rate where the US dollar is the home currency (US dollar per one euro). (3 marks) (3) As mentioned above, the dollar value of the funds to be received next month is estimated at $500,000 for the euro, what is the expected loss in the amount of US dollar based on the maximum 1- month loss from part (1) above? Apply the Value-at-Risk (VaR) method to estimate transaction exposure to exchange rate movements and answer the following questions. Assume that the monthly percentage changes of each currency and the monthly percentage changes of the portfolio are normally distributed. The maximum 1-month loss of the currency portfolio is determined by the lower boundary (the left tail) of the probability distribution which is about 1.65 standard deviations away from the expected percentage change in the currency portfolio. The home country is the U.S. and therefore the home currency is the U.S. dollar. Pfizer Corporation, a U.S. exporting firm, expects to receive payments denominated in both euro () and British pound () in one month. Based on today's spot rates, the dollar value of the funds to be received next month is estimated at $500,000 for the euro and $500,000 for the pound. The company is exposed to a currency portfolio consisting of only the euro and the pound. The company wants to determine the maximum expected 1-month loss due to a potential decline in the value of these currencies (downside risk), based on a 95% percent confidence level. Based on the data for the last 60 months, it estimates the standard deviation of monthly percentage changes to be 7 percent for the euro and 8 percent for the pound. The correlation coefficient (CORR or p) between the euro and the pound is 0.30. (Note: Make sure that all the signs (+/-) of your answers are accurate.) (a) Assume that the expected percentage change for the euro during the next month is -2%. (1) What is the maximum 1-month loss of euro in percentage? (3 marks) (2) Suppose the spot rate of the euro (S) is $1.20/euro. Based on the maximum 1-month loss that you obtain from part (1) above, what is the euro value? That is, if this maximum one- day loss occurs, what will the euro's value decline to? Answer this question using the direct quote of exchange rate where the US dollar is the home currency (US dollar per one euro). (3 marks) (3) As mentioned above, the dollar value of the funds to be received next month is estimated at $500,000 for the euro, what is the expected loss in the amount of US dollar based on the maximum 1- month loss from part (1) above
