Foreign Exch Risk Instntl Issues & Modeling

8/8/2019 Foreign Exch Risk Instntl Issues & Modeling

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Foreign Exchange Rate Risk:Institutional Issues and Stochastic Modeling

Richard W . Gorvett, FC A S, M A A A ,ARM , Ph.D.

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Biography

Rack Gorvett is an Assistant Professor of Actuarial Science at the University of Ilhnols atUrbana-Champalgn He recewed a BS m Mathematics fi'om the Umverslty of Illinois atChicago, an MBA m Fmance and Econometrics from the Umversity of Chicago, and a Ph D. mFinance and Insurance from the Umvers~ty of Illinois at Urbana-Champalgn

At the University of llhnols, Rack teaches undergraduate and graduate courses m the theory ofinterest, actuarial modehng, and actuarial risk theory Prior to h~s current position, he was on thefaculttes of The College o f Insurance and the Finance Department at the Umverslty of llhnols,where he taught insurance, risk management, finance, and financial risk management. Rack'sbackground includes business experience as an actuary and consultant Specific research andconsulting interests include dynamic financml analysm, insurance secuntlzat~on, and the use offinancml models in determining insurance rates

Rack is a Fellow of the Casualty Actuarial Society, a Member of the American Academy ofActuaries, and has the Associate in Rask Management designation

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Ab s t r a c t

Th e increas ing g loba l i za t ion of the proper ty-habdl ty insurance indus t ry has p rov id ed insurer sw i t h b o t h o p p o t ~ m t i e s an d ch a l len g es . T h e o p p o n ' u rn t ie s r ev o l v e n ew m ar k e t s w i t h p r o fi tpo ten t i a l and d iver s i f i ca t ion poss ib i l i ti es . On the o the r hand , co m pam es w~th mu l t ina t iona lopera t ions and/or inv es tmen ts a re expo sed to the r isk tha t fo re ign exch ange r a tes w i l l change ,poss ib ly adver se ly , in the fu ture . T ins paper exam ines the sources o f fo re ign exchan ge r i sk , and

&scusses the ins ti tu t iona l t echniques - e .g , f inanc ia l denvat~ves - avad able to comp am es toma nage tha t ri sk . Som e anecdota l ev idence i s p rov ide d to ind ica te how s om e insurers ac tua l lydo ma nage fore ign exchange r isk. F ina l ly , the paper b r i e f ly descr ibes som e poss ib le approachesto the mo del ing of fo re ign excha nge r i sk , fo r exam ple m a dynam ic f inanc ia l analys~s contex tW hen m odel ing , the mterrelataonsh ips be twe en exc hang e ra tes and o ther var iab les - e .g ., in te res tr a tes and in f l a t ion r a tes m the . r e levant count r i es - mus t be co ns idered and r e f l ec ted

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S e c t i o n 1 - I n t r o d u c t i o n a n d O v e r v ie wT h e r e c e n t " g l o b a l i z a t i o n " o f t h e p r o p e r t y - h a b t h t y i n s u r a n c e in d u s t r y h a s o c c u r r e d o n s e v e r a ll e v e ls . U . S . - b a s e d i n s u r e r s h a v e e x p a n d e d I n to fo r e i g n m a r k e t s - w i t h v a r ) q n g d e ~ e e s o fd ~ f f ic u lt y a n d s u c c e s s - i n o r d e r t o a t te m p t t o ta k e a d v a n t a g e o f p e r c e i v e d o p p o r t u n i t i e s O n t h eo t h e r h a n d , m a n y l a rg e E u r o p e a n i n s u r a n c e o r g a m z a t ~ o n s n o w h a v e s i g n i f i c a n t p r e s e n c e s m t h eU m t e d S t a te s . T h e s e v a r i o u s m u i r , n a t i o n a l e f f o r ts h a v e o f t e n b e e n a c h i e v e d t h r o u g h m e r g e r a n da c q u i s i t io n a c t i v it y . F u r t h e r m o r e , w ~ th th e m a t u r a t i o n o f t h e g l o b a l f i n a n c i a l m a r k e t s ( i n c l u d i n g

t h e d e v e l o p m e n t o f n e w d e n v a a v e p r o d u c ts ) a n d a v a r ie t y o f t e c h n o lo g i c a l a d v a n c e s ,m u l t i n a t io n a l o p e r a t t o n s h a v e b e c o m e i n c r e a s i n g l y f e a si b l e a n d e f f ic i e n t.

H o w e v e r , f o r i n s u r e r s ( a s w e l l a s f o r o t h e r f i r m s ) , t h e p o t e n t i a l a d v a n t a g e s o f g l o b a l i z a t l o n a r ea c c o m p a m e d b y a d d i t io n a l o p e r a t i n g n s k s W h e n e v e r a n i n s u r e r o p e r a t e s m m u ltm p le c o u n t r i e sw i t h d i f f e re n t c ur re n c i e s , the i nsu re r is sub j e c t t o fo re i gn e xc h a ng e (FX) r i sk . Esse n t i a l l y , t h i s i st h e r is k t h a t t h e v a l u e r e l a u o n s h l p b e t w e e n t h e i n s u r e r ' s " h o m e " c u r r e n c y a n d t h e c u r re n c y o f af o r e i g n c o u n t r y in w h i c h t h e i n s u r e r o p e r a t e s o r i n v e s t s w i l l c h a n g e m t h e f u t u r e S u c h c h a n g e sh a v e t h e p o t e n t m l t o e m th er a d v e r s e l y o r f a v o r a b l y a f f ec t t h e e c on o m m c a n d / o r a c c o u m m g c a s hf lo w s a n d a s s e t / h a b i h t y v a l u e s o f a c o m p a n y . A c o m p a n y ' s a b d l t y t o co m p e t e i n t e rn a h o n a l l ywi l l de pe n d , a t l e a s t m pa r t , on t t s a bd~ t y t o a pprop r i a t e l y a nd e f fe c t i ve l y ma n a ge t h e r i sksI n t r o d u c e d f r o m m u l t i n a t io n a l o p e r a t io n s .

T h i s p a p e r e x a m i n e s F X r i s k a n d i t s p o t e n t m l e f f ec t o n p r o p e r t y - h a b i l i ty in s u r e r s . S e c t i o n 2p r e s e n t s a d e s c r i p t io n o f t h e n a a u ' an d c h a r a c t e r is t ic s o f th i s n s k B e f o r e p r o c e e d i n g w i t h ad i s c u s s i o n o f h o w t h i s n s k c a n b e a d d r e s s e d , S e c ti o n 3 a s k s a b a s i c q u e s h o n : i s t h e r e a n y

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" v a l u e " a s s o ct a te d w a th t he " h e d g i n g " p r o c e s s? S e c t i o n 4 e x a m m e s t h e r i sk m a n a g e m e n tt e c h m q u e s , m c l u d i n g f i n a nc i a l d e r iv a t tv e s , a v a i la b l e to i n s u r e r s to m a n a g e F X r i sk , a n d S e c t t o n5 p r o v i d e s s o m e a n e c d o t a l m f o r m a t l o n r e g a r d i n g t h e u s e o f s u c h t e c h n i q u e s b y p r o p e rt y - li a b il i tyi n s u r e r s S e c t i o n 6 b n e f l y d ~ s c u s se s s o m e o f t h e t s s u e s r e v o l v e d i n st o c h a s t tc a l l y m o d e h n g F Xr i sk s ; s u c h m o d e l i n g h a s i m p o r t a n t a c t u a ri a l a p p l ic a t io n s , f o r e x a m p l e w i t h r e g a r d t o e f f o r ts tos i m u l a t e F X r i sk w i t h i n t h e f r a m e w o r k o f d y n a r m c f i n a n c ia l a n a ly s t s . S e c t i o n 7 p r o v td e s as u m m a r y a n d c o n c lu s io n

S e c t io n 2 - F o r e i g n E x c h a n g e R a t e R i s k.A . W h a t t s a n E x c h a n g e R a t e 9W h e n c o m p a n i e s o r m d t v i d u a l s e n g a ge t h e m s e l v e s m a c ti v it ie s i n v o l v i n g c a s h f l o w sd e n o m i n a t e d i n d i f f e re n t c u r r e n c t e s ~, t h e v a l u e r e l a t i o n s h ip b e t w e e n t h o s e c u r r e n c i e s b e c o m e si m p o r t a n t. T h i s r e l a t io n s h i p I s e x p r e s s e d a s a ore ign exchange ra te , w h i c h f o r o u r p u r p o s e s w ew i l l t ak e t o m e a n t h e n u m b e r o f f o re t g n c u r r e n c y u n i t s t h a t c a n b e p u r c h a s e d w i t h o n e U . S .d o ll a r. 2 T h e r a te a t w h i c h c u r r e n c i e s c a n b e e x c h a n g e d t o d a y ( f o r " i m m e d i a t e d e l i v e r y '3 ) tsr e f e r r e d t o a s t h e spot r a te o f e x c h a n g e , t h e r a te , a g r e e d u p o n t o d a y , a t w h i c h c u r r e n c i e s c a n b ee x c h a n g e d i n t h e f u t u r e ( f o r " f u t u r e d e l i v e r y " ) t s r e f e rr e d t o a s t he o rward r a te o f e x c h a n g e .

i A "currency" ca n be backed by a comm odlty , or i t can be unbacked The lat ter, used m mdusmal)zcd countries , Isoften called a "fiat" currencya Tl us is known as an "redirect" qunte Alternauvely, exchange rates can bc quoted as the reciprocal of this ratxo-namely, dollars per forelgn currency um t, thts ts called a "&rect" qu ote In the fmanclal press, exchange rates areoften hste d both ways3 Techm cally, a sp ot FX rate refers to a trade that settles m two b usin ess days

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T h e t a b le b e l o w g w e s s a m p l e s p o t an d f o r w a r d e x c h a n g e r a te s a s o f N o v e m b e r 7 , 2 0 0 0 4

T a b l e 1E x c h a n g e R a t e s as o f N o v e m b e r 7 , 2 0 0 0

( Q u o t e d a s C u r r e n c y p e r U S D o l l a r )1 M o n t h 3 - M o n t h 6 - M o n t h

S p o t F o r w a r d F o r w a r d F o r w a r dB n u s h P o u n d 0 6 9 7 2 0 6 9 6 8 0 6 9 5 9 0 . 6 9 4 8F r e n c h F r a n c 7 6 2 2 5 7 6 1 1 5 7 . 5 9 0 8 7 . 5 6 5 8G e r m a n M a r k 2 2 7 2 8 2 2 6 9 5 2 2 6 3 3 2 . 2 5 5 9J a p a n e s e Y e n 1 0 6 . 9 9 1 0 6 4 0 1 0 5 3 3 1 0 3 7 7

T h u s , a c o m p a n y w a n t i n g t o c o n v e r t 1 0 , 0 0 0 , 0 0 0 F r e n c h f r a n c s i n t o U . S . d o l l a r s o n a s p o t b a s i sw o u l d r e c e tv e

F F I 0 , 0 0 0 , 0 0 0 - 7 6225FF/$ = $ 1 , 3 1 1 , 9 0 5 5 4E x c h a n g i n g i n t h e o t h e r d i re c ti o n , a c o m p a n y w a n t i n g t o c o n v e r t $ 5 , 0 0 0 ,0 0 0 t o B r it i sh p o u n d so n a s p o t b a s ~s w o u l d g e n e r a t e

$ 5 , 0 0 0 , 0 0 0 x 0 6 9 7 2 / $ = 3 , 4 8 6 , 0 0 0( B o t h o f t h e s e e x a m p l e s i g n o r e a n y t m n s a c h o n s f e e s o r o th e r " e x p e n s e s . " T h e u s e o f f o r w a rdr a t es w d l b e d l u s t r a t e d l a t e r )

B F o r m s o f E x c h a n g e R a te R a skA s w i t h m a n y o t h e r s o u r c e s o f f i n a n c ia l r is k , s u c h a s i n t er e st r at e a n d c o m m o & t y p r i c e r is k , th el ev e l o f F X r i sk t o w h i c h c o m p a n i e s a n d i n d i v i d u a ls a r e s u b je c t h a s m c r e a s e d s i g n i f i c a n t l y

( Per Th e Wall Street Journal, Wednesday, November 8, 2000, page C21 The rates shown are New York foreignexchange nud-mnge rates, apphcable to trading among banks, m amounts of$1 rmlhon or more

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du nng the last few decades. Specifically with regard to foreign exchan ge rates, the breakdownof the Bretton Wo ods Agreemen t s in the early 1970s led to a more volatile envir onment m whichd~fferent currenc ies often fluctuate - some times significantly - relatwe to one anot herCombi ned with increased volatdlty m other financml variables - e g, U S interest rates6 - thisincrease m foreign exchange volatlhty has caused multinational operations and investments to bepotentmlly qmte risky

Charts of monthly ttme senes for several foreign exchange rates are appended to the end of thispaper. 7 Thes e charts exhibit the volatdity inherent m the foreign exchan ge relationshipRecogmzmg and quanttfylng that volatility is important, as volatd~ty is one posstble measure ofthe level of risk

Expos ure to foreign exchan ge risk can take several d~fferent forms.

Transacnon exposure" arises from transactions mvolving future cash flows wluch aredenomina ted in a curren cy dtfferent fi'om the "hom e" curren cy Ttus type of risk occurswhen the relevant exchange rate changes between the date a transaction agreement ts enteredinto and the date the transaction is financially consu mmat ed. Exam ples of such exposuresmight include:

s In July, 1944, representatives of 44 countries met m Bretton Woods, New Hampslure, where they reached anagreement to achieve relative currency stabdity by adopting a system of fixed exchange rates The system revolved6pegging foreign currencies to the U S dollar, which was m turn pegged to gold This lasted untd the early 1970sU S interest rates became more volatile m 1979, when the Federal Reserve, under Chakrman Paul Volcker,essentially swatched fi-oma pohcy revolvingstabthzmg Interest rates to one involving conu'olhng inflationData for these charts is taken from the Federal Reserve Bank of St Louts' Federal Reserve Econormc DatafiRED) webstte www stls frb org/fred/

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o Revenues and expenses associated w~th a U S. parent company's foreign subsidiaryFor example, if the dollar strengthened or apprecmted relattve to the foreign currency(i. e, if the U S dollar now bought more umts of the foreign currency), foreignrevenues would be depreciated on a dollar basis (the foreign revenues would be worthless when converted to U S dollars than they would have been had the dollar notstrengthened)The purchase and financing of assets m another currency A classic example

(mentioned m both Smlthson (1998) and Campbell and Krakaw (1993)) revolves thenow-de funct Laker Alrhnes In the late 1970s, the U S dollar was weak relatwe tothe Bntmh pound, and thus there was s~gmficant demand among the British forvacahons in the U S In response to this demand, Laker A~rhnes purchased severaladd~tlonal planes, financing them m U S dollars When, m the next few years, thedollar strengthened relative to the pound, Laker A~rhnes had a double problem (1)its revenues were in pounds and ~ts debt largely m dollars (a mismatch which,because o f the strengthened dollar, affected the company adversely), and (2) thedemand for U S vacahons among the British fell (due to the no longer favorableexchange rate) The first problem resulted from a transaction exposure, the secondresulted from an operatmg exposure (see below). Laker Airhnes went bankrupt m

1982Translatton exposure an accounting-based exposure resulting from a company 's havmg toconvert asset and/or habdlty ~tems from one currency to another for financial statement.purposes This can occur, for example, when a U S parent company must restate the(foreign-denominated) assets and llabdmes of a forezgn subsldmry in U S dollars for the

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p a r e n t c o m p a n y ' s f i n a n c i al st a t e m e n t s . T h e d e g r e e o f th i s r i s k d e p e n d s u p o n t h e s p e c i f i ca c c o u n t i n g r u l e s p e r t a i n i n g to t h e e x c h a n g e r a t e m o v e m e n t s a n d t h e f i n a n c m l ~te m s i n v o l v e dO p e r a t i n g ex p o s u r e : a n e x p o s u r e a s s o c m t e d w ~ th t h e p o t e n t i a l s m p a c t o f c h a n g e s i ne x c h a n g e r a t e s o n t h e f u t ur e c a s h f l o w s o f t h e c o m p a n y T h ~s c a n a l s o b e r e f e r re d t o ase c o n o m s c e x p o s u r e , s i n c e t h e e c o n o m i c v a l u e o f a c o m p a n y ~s a f u n c t s o n o f t h e f i r m ' s f u t u r ec a s h f l ow s T h e a b o v e - m e n t i o n e d s e c o n d p ro b l e m e x p e r ie n c e d b y L a k e r A s r h n e s - t h ec h a n g e m d e m a n d f o r v a c a u o n s a n d t h e r e s u l t in g ds m m ~ s h e d r e v e n u e s t r e a m d u e t o t h e

s t r e n g t h e n e d d o l l a r - s s a n e x a m p l e o f t h~ s t y p e o f e x p o s u r e

S e c t io n 3 - W h y B o t h e r t o H e d g e ?No w tha t t he sou rc es o f F X r i sk h ave be en sden t~ fi ed , s t seem s log ica l t ha t t echnxques fo rm a n a g i n g t h a t n s k b e c o n s s d e re d , a n d t t s s c o n c e s v a b l e th a t o n e r e a s o n a b l e t e c h nx q u e m a ym v o l v e t h e " h e d g i n g " o f s u c h ri s k s , f or e x a m p l e v s a c e r t a in f i n a n c m l d e n v a t s v e s T h e s e t o o lsw i l l i n d e e d b e d~ se us se d b e l o w . H o w e v e r , a b a s t e q u e s u o n m a y j u s t i f i a b l y b e a s k e d b e f o r ep r o c e e d i n g ' w h y b o t h e r t o h e d g e w t t h d e r iv a t i v e s a t a l l ? I n o t h e r w o r d s , u n d e r w h a tc s r c u m s t a n c e s , f f a n y , w i l l h e d g i n g a c t u a l l y s e r v e t o " t m p r o v e " t h e c o m p a n y ' ~

T o r e s p o n d t o t h~ s I m p o r t a n t i ss u e , c o n s i d e r th e f i n a n c m l r is k m a n a g e m e n t ( F R M ) p r o c e s s f r o ma b r o a d p e r s p ec t s v e F m a n c m l n s k m a n a g e m e n t c a n b e c o n s s d e r e d t o in c l u d e th e f o l l o w i n gs t eps

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1 ) D e t e r m i n e t h e c o r p o r a U o n ' s o b j e c t iv e s ( e g , s o l v e n c y , p r o f i ta b i l it y , il q m d i t y )2 ) Iden t i fy t he r i sk expo su re (e .g , F X r i sk , i n t e re s t ra t e r i sk )3 ) Q u a n t i f y t h e ri s k e x p o s u r e ( e g. , m e a s u r e t h e v o l a t il i ty )4 ) A s sess t he im pac t o f t he r isk on . the f i rm (e g ., s ens i t i v i t y ana ly s i s , dyn am ic f i nanc i a l

a n a l y s i s )5 ) E x a m i n e a l t e rn a t i v e f i n a n c ia l r i sk m a n a g e m e n t t o o l s ( e g , d e r i v a t i v e s )6 ) S e l e c t a n a p p r o p n a t e f in a n c i a l r i sk m a n a g e m e n t t e c h n i q u e7 ) I m p l e m e n t t h e F R M t e c h m q u e8 ) M o n i t o r t h e F R M p r o g r a m f o r e f f e c t iv e n e s s

S t e p 5 , s o m e a l t e r n a ti v e to o l s a n d t e c h n i q u e s a v m l a b l e fo r m a n a g i n g F X r i s k , w i l l b e a d d r e s s e db e l o w . H o w e v e r , a n i m p o r t a n t q u es U o n Is th ~s : c a n f i n a n c ia l r i s k m a n a g e m e n t t e c h n i q u e si n c r e a s e f i n n v a l u e ? G i v e n t h e p r e v a l e n c e a n d im p o r t a n c e o f s u c h t e c h n i q u e s - t h e d e n v a t i v e sm a r k e t is I m m e n s e - t h e an e c d o t a l a n s w e r w o u l d s e e m t o b e " y e s . " H o w e v e r , t h i s q u e s t i o n i sr e a l ly a s u b s e t o f a m o r e g e n e r a l q u e s t io n a s t o w h e t h e r o r n o t t h e m e t h o d o f f i n a n c i n g ac o m p a n y - e q u i t y v e rs u s d e b t , o r t h e o v e r a l l n a t u r e o f t h e n g h t - h a n d s i d e o f t h e b a l a n c e s h e e t -c a n a f f e c t fi r m v a lu e . I n 1 9 5 8 , M i l l e r a n d M o d l g h a n i g a v e a q u a l i f ie d " n o " : u n d e r c e r t a inassum pt ions , a f i rm ' s f i nanc ing is i r re l evan t t o i ts va lue , beca use va lue i s de t e rm ined on t he l e f t-h a n d s i d e o f t h e b a l a n c e s h e e t I n o th e r w o r d s , w h a t I s i m p o r t a n t I s n o t h o w t h e c o m p a n y r i n se sm o n e y , b u t r a t h e r w h a t t h e c o m p a n y d o e s w i t h t h e m o n e y - e g ., i n t e r m s o f c a p i ta l i n v e s t m e n t -a f t e r t t ' s b e e n r a is e d S i n c e f i n a n c ia l r i s k m a n a g e m e n t te c h n i q u e s e s s e n ti a l ly m v o l v e t h ef i n a n c i n g o f t h e c o m p a n y , t h e q u e s t io n c a n r e a s o n a b l y b e a s k e d a s t o w h e t h e r m a n a g i n gf inanc i a l r i sk i s w or thw h i l e

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The key to this issue ~s to understand the assumptions that Mod~gllan~ and Miller made mdevelopmg their irrelevance proposition. They assumed no tax effects, no costs of financmldistress, and a fixed investment policy Thus, if financml nsk management techmques are tomatter, at must be through the violation of one or more of those slmphfymg assumptions

T a x e f f e c t s If the tax function is c o n v e x (I e , if the marginal tax rate increases as incomeincreases), financmg policy might matter, because more volatde earnings can result m agreater average tax liability Fmanclal risk management can thus add to company value bydecreasing the volatthty o f tts future earnings stream, and thereby potentially reducingexpected taxes

F z n a n c z a l d t s t r e s s / b a n k r u p t c y c o st s" If a company, Is htghly leveraged or somehowthreatened by insolvency, it may behave in ways which are not optimal (e g, by favoringhigh-risk mvestments) Financial risk management can add value by encouraging betteroperational behavior through lowenng the costs o f financial distress

F u t u r e t n v e s t m e n l d e c ts t o n s" Ifa company experiences losses, sound Investmentopportumt~es m~ght be "crowded out." If there are insufficient internal funds to financesound investments, the company may have to raise more costly external capital ~f~t stdlwmhes to make those investments. By reducing the potentml impact of losses through FRM,therefore, the company may be able to promote better capital investment behavior

Graptucally, the effect of financial risk management techniques can be illustrated as a reductionm the variance (volatlhty) o f future cash flows.

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I m p a c t o f F i n a n c i a l R i s k M a n a g e m e n to n C a s h F l o w V o l a ti li ty

P o s t - F l

Cash Flow

T h u s , It d o e s a p p e a r t h a t F R M t e c h n i q u e s c a n b e b e n e f i c ia l t o a fi r m , p r i m a r i l y b y r e d u c i n g t h ev o l a t l h t y o f f u tu r e r e s u l t s 8 A d i s c u s s i o n o f s o m e o f t h e s e F R M t e c h n i q u e s f o l l o w s m t h e n e x tsect ion

S e c t i o n 4 - T e c h n i q u e s f o r M a n a g i n g F X R i s kA v a r i e t y o f t e c h m q u e s c a n b e u s e d t o m a n a g e f o re i g n e x c h a n g e r at e ri sk . D e s c r i p t i o n s o f s o m eo f t h e s e t e c h m q u e s a p p e a r b e l o w I n o r d e r to i ll u s tr a te t h e d i f f e r e n c e s b e t w e e n a n dc h a r a c t er i s ti c s o f t h e s e t e c h n i q u e s , a c o m m o n e x a m p l e w d l b e u s e d t h r o u g h o u t s e v e r a l o f t h e s ed e s c ri p t io n s " s u p p o s e th a t a U S i n s u r a n c e c o m p a n y m u s t m a k e a h a b l h t y p a y m e n t o fD M I 0 , 0 0 0 ,O 0 0 i n s ix m o n t h s T h e c o m p a n y , s e x p o s e d to F X r is k b e c a u s e o f t h e u n c e r t am t ya s s o c i a t e d w i th t h e re l a ti v e v a l u e o f D e u t s c h e m a r k s a n d U S d o l l a rs s i x m o n t h s f r o m n o w

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A B a l a n c e S h e e t H e d g e sI f a c o m p a n y c a n t ak e a p o s m o n w h i c h o f f s e t s a f o r e i g n - d e n o m i n a t e d a s s e t o r h a b d t t y o n ~tsf i n a n c i a l s t a t e m e n t s , tt t s p o s s i b l e t h a t t h e f o r e i g n e x c h a n g e r ts k c a n b e a t l e a s t p a r t m l l y h e d g e dW h e n t h i s i s d o n e , t h e c o m p a n y h a s p e r f o r m e d a n " o n - b a l a n c e s h e e t h e d g e " F o r e x a m p l e , i f ac o m p a n y k n o w s t h a t ~t w d l n e e d t o m a k e a f u t u r e h a b d ~ ty p a y m e n t d e n o m i n a t e d m a f o r e ig nc u r r e n c y , i t c o u l d t a k e U S d o l l a r s , c o n v e r t t o t h e f o r e i g n c u r r e n c y a t t h e s p o t e x c h a n g e ra t e , a n dt h e n m v e s t m f i n an c i a l a s s e t s t h a t a r e d e n o m m a t e d m t h e f o re i g n c u r r e n c y I n t h e c a s e o f o u rD e u t s c h e m a r k e x a m p l e , f o r t h i s t y p e o f h e d g e t h e c o m p a n y w o u l d n e e d ( m d o l l a r - d e n o m i n a t e dc a s h ) th e s i x - m o n t h p r e s en t v a l u e o f D M I 0 , 0 0 0 , 0 0 0 o n a s p o t b a s i s

D M 1 0 , 0 0 0 , 0 0 0 - 2 2 7 2 8 D M / $(1 + t o . ,1 ) o 5w h e r e r o , I t s t h e G e r m a n r i s k - fr e e in t e re s t r at e T h ~ s d o l l a r - d e n o m i n a t e d a m o u n t o f c a s h c o u ldb e c o n v e n e d , n o w , t o D M , a n d t h e n m v e s t e d a t rDM SO t h a t , m s ~x m o n t h s , t h e D M I 0 , 0 0 0 , 0 0 0h a b t h t y p a y m e n t w o u l d b e c o v er e d

M o r e d t r e c t ly , i f t h e f i r m a l r e a d y h a s a s s e t s d e n o m m a t e d i n th e f o r e i g n c u r r e n c y , t t c o u l d" e a r m a r k " s o m e o f t h e m f o r t h e u p c o m i n g h a b d l t y p a y m e n t S ~ m d a r ly , a U . S - b a s e d c o m p a n yw t t h a f o r e i gn s u b s ~ d m r y t h at d o e s b u s m e s s m a f o r e ig n c u r r e n c y c o u ld u s e s o m e o f t h e

s u b s ~ d m r y 's f o r e tg n - d e n o m m a t e d r e v e n u e s t o p a y s o m e o f ~ ts s u b s l d m r y ' s f o r e t g n - d e n o m m a t e de x p e n s e s , th u s m m t m l z m g t h e a m o u n t o f c u rr e n cy e x c h a n g i n g r e q u ir e d

s It may also be advantageous for a company to engag e In financLal risk management ac tw m es to the extent that ~t

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B FX For wa rd and Futures ContractsF o r w a r d s a r e p e r h a p s t h e m o s t b as i c f o rm o f fi n a n c ia l d e n v a t l v e A f o r w a r d m v o l v e s a no b h g a t o r y a g r e e m e n t b e t w e e n t w o p a r t , es ( o f te n c a l le d counterparttes) t o e n t e r i n t o a t r a n s a c t i o na t s o m e f u t u r e d a t e ( th e ~ p t ra t to n o r m a t u r i t y d a t e) T h e t r a n s a c t i o n in v o l v e s e i th e r b u y i n g o rs e l h n g a n underlying a s s et . N o p a y m e n t t s m a d e u n t i l th e m a t u r i t y o f t h e a g r e e m e n t , a n d t h e nt h e t ra n s a c t io n Js c o n s u m m a t e d a t t h e dehveryprtce , e i th e r t h r o u g h p h y s i c a l d e h v e r y o r a c a s hs e t t l e m e n t ( d e p e n d i n g u p o n t h e t y p e o f a s s e t r e v o l v ed a n d t h e a g r e e m e n t o f t h e pa r ti e s) T h ep a r t y a g r e e i n g t o b u y t h e u n d e r l ) q n g a s s e t i s r e fe r r ed t o a s t a k i n g t h e long p o s m o n , a n d t h e p a r t ya g r e e i n g t o s e l l t h e u n d e r l2 , a n g a s s e t , s m t h e short p o s i t i o n . F o r w a r d s c a n b e t m l o r - m a d e t o f itt h e c o u n t e r p a r h e s ' p a r ti c u la r s i t u a t i o n s

W i t h r e s p e ct t o t h e D M 1 0 , 0 0 0 ,0 0 0 h a b t h t y p a y m e n t e x a m p l e , t h e i n s u r a n c e c o m p a n y c o u ldh e d g e t h e F X r i s k i n h e r e n t i n th e f u t u r e h a b t h t y p a y m e n t t r a n s a c t i o n b y e n t e n n g , n o w , i n t o a s ~ x-m o n t h f o r w a r d c o n t r a c t T h ~ s w o u l d b e a n a g r e e m e n t w i t h a c o u n t e r p a r t y t o p u r c h a s e s t x m o n t h sf r o m n o w , a t a p r e - s p e c l f i e d p r ic e , D M 1 0 , 0 0 0 , 0 0 0 T h a t p r e - s p e c l f i e d p r i c e w o u l d b e t h e s i x -m o n t h D M / $ f o r w a rd r at e T h u s , t h e i n s u r a n c e c o m p a n y w o u l d a g r e e to p a y , m s i x m o n t h s ,

D M I 0 , 0 0 0 , 0 0 0 - 2 2 5 5 9 D M / $ = $ 4 ,4 3 2 ,8 2 0 6 0m e x c h a n g e f or t h e D M 1 0 , 0 0 0 , 0 0 0 ~t n e e d s to m a k e t h e h a b t h t y p a y m e n t B y e n t e n n g i n t o af o rw a r d , t h e c o m p a n y h a s l o ck e d m t h e ' e x c h a n g e ra te s t x m o n t h s f i 'o m n o w , t h u s e l i m m a t m g t h ep o t e n tm l F X v o l a t t h t y o v e r t h e n e x t s~x m o n t h s N o t e t h a t t h i s m a y o r m a y n o t e n d u p h a v m gb e e n a p r o f i ta b l e t r a n s a c t i o n f o r t h e c o m p a n y , d e p e n d i n g u p o n t h e a c t u a l s p o t e x c h a n g e r at e th a te m e r g e s s~ x m o n t h s f r o m n o w

can do s o more efticlently and at lower cost than can mthvldual stakeholders m the company

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One tssue assocmted with forwards ~s the abd~ty of the counterparty to meet its contractualobhgation when the transact)on date amves Forwards are sometimes called "pure credttinstruments" since the only uncertainty wtth respect to the transactton is the ablhty of each partyto perform up to tts obligations These performance issues are addressed by a denvatw e that isclosely related to the forward the future.

Futures contracts are similar to forward contracts, except that they are standardized9 and tradedon exchanges. The exchange provides a number ofmechamsms to mlnlm)ze the couterpartydefault nsk: (1) dady settlement (or marking to market), m which the profit or loss resultingfrom the movement m the value of the underlying asset is recogmzed on the account of eachparty to the futures contract each day, (2) margins, which revolve the posting of capital to helpensure performance, and (3) the exchange cleannghouse, which helps to further guarantyperformance by interposing itself between the seller and buyer m futures transactions Currencyfutures are traded on major currencies, and are (as are other types of futures) tdentffied accordmgto the month dunng which they exptre

C F X O p t t o n sAn option Is similar in some ways to a forward, although there are several critical distinctionsThe primary thfference ~s that an option involves the right, not the obhgation, to consummate afinancial transaction As with other denvatwe instruments, two parties are revolved m an optiontransaction one buys (is "long") the option, and one sells Os "short") the option The option

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b u y e r - t h e p a r t y th a t h o l d s t h e o p t i o n - h a s t h e r ig h t t o e x e r c i s e t h e o p t i o n , a n d w i l l o n l y d o s oi f e x e r c i s e i s f in a n c i a l ly s u p e r i o r t o n o n - e x e r c i s e D e p e n d i n g u p o n t h e t y p e o f o p t i o n , th e h o l d e rh a s t h e n g h t t o e ~ t h er b u y ( a c a l l o p h o n ) o r s e ll ( a p u t o p t i o n ) t h e u n d e r l y i n g a s s e t a t t h e e x e r c i s ep r i c e A l s o d e p e n d i n g u p o n t h e t y p e , t h e o p t io n m a y b e e x e r c i s e d e i t h e r a t a n y t i m e b e f o r e i te x p i r e s ( a n A m e r w a n o p t io n ) , o r o n l y o n t h e e x p ir a ti o n d a t e o f t h e o p h o n ( a E u r o p e a n o p t i o n )

T h e p r i c e i m t m l l y p a i d f o r th e o p t i o n i s ty p i c a l ly r e f e r re d t o a s t h e p r e m m m . T h i s p r e m i u m i s a

f u n c t i o n o f f i v e p a r a m e t e r s - t h e v a l u e o f t h e u n d e rl 3 n n g as s e t, t h e e x e r c i s e p r i c e , t h e i n t e r e str a te , t h e t i m e u n t il e x p i r a t i o n o f t h e o p t i o n , a n d t h e v o l a t i li t y o f t h e p r i c e o f t h e u n d e r l y i n g a s s e t.I n p r a c t ic e , t h e r e a r e s e v e r a l t e c h n i q u e s ( d e p e n d i n g u p o n t h e s p e c i f i c c h a r a c t e r i st i c s o f t h eo p t i o n ) f o r d e t e r m i n i n g a p p r o p r i a t e p r e m i u m v a l u e s f o r o p t i o n s , i n c l u d i n g th e b i n o m i a l m e t h o da n d t h e B l a c k - S c h o l e s p r i c i n g e q u a t io n

O p t i o n s c a n b e u s e d i n c o m b i n a t i o n w ~ th o t h e r f i n a n c m l i t e m s t o p r o v i d e " p r o t e c t i o n " o n t h o s ei t e m s F o r e x a m p l e , o w n i n g a n a ss e t s u c h a s s t o c k a n d a l so o w n i n g a p u t o p h o n o n t h a t s t o c k( k n o w n a s a " p r o t e c t w e p u t " p o s~ t~ on ) p r o v i d e s p r o t e c t io n w ~ th r e s p e c t t o t h e d o w n s ~ d e p o t e n tm lo f t h e s t o c k l g n o n n g t h e p r e m i u m p a id f o r t h e p u t, t h e c o m b i n e d s t o c k - a n d - p u t p o r t f o h o v a lu ec a n n o t f a ll b e l o w t h e e x e r c i s e p r ic e o f th e p u t T h i s i s b e c a u s e t h e v a l u e o f th e p u t o f f s e t s t h e

d l m l m s h e d v a l u e o f t h e s t o c k t o th e e x t e n t t h a t t h e s to c k p r i c e f a l ls b e l o w t h e e x e r c i s e p r i c eS i m i l a r ly , c a ll o p t i o n s c a n b e c o m b i n e d w i t h h a b l l lt l e s t o p r o v i d e u p s i d e ( c e l h n g ) p r o t e c t io n

9 Standardization has advantages and disadvantages Expen ses associated with a standar&zed product nugh t belower, but there is less flexlblhty avadable to tador the instrument o a specific situation

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W t t h r e s p e c t to F X o p t i o n s , c a ll s a n d p u t s c a n b e u s e d t o p r o t ec t a g a m s t u n d e s i r e d p o t e n t ta lm o v e m e n t s m t h e F X r a t e C o n s t d e r o u r D M I 0 , 0 0 0 , 0 0 0 h a b d l t y p a y m e n t , d u e m s ix m o n t h sT h e i n s u r a n c e c o m p a n y ' s f e a r ~s t h a t t h e d o l la r w a ll d e p r e c t a t e r e l a t i v e t o t h e m a r k ( o r t h a t t h em a r k w , l l s t r e n g t h e n r e la t tv e t o t h e d o l l ar ) o v e r t h e n e x t s t x m o n t h s , m e a n i n g t h a t th e c o s t o f t h el ia b il it y p a y m e n t w o u l d b e g r e a te r m t h e c o m p a n y ' s h o m e c u r re n c y (d o l l ar s ) T h e c u r r e n t sp o tr at e ts , s a y , 2 . 2 7 2 8 D M / $ , o r, e q u i v a le n t l y , 0 4 4 0 0 $ / D M T h u s , t h e c o m p a n y ' s f e ar ts t h at th e$ / D M e x c h a n g e ra t e w a ll in c r e a s e ( O n t h e o th e r h a n d , th e c o m p a n y w il l b e n e f i t f f t h e $ / D M r at ef a ll s ) P e r h a p s t h e c o m p a n y Is w d h n g t o t a k e s o m e F X r is k - b u t w a n t s t o h e d g e t h e p o s s i b t h t y ,f o r e x a m p l e , th a t t h e e x c h a n g e r at e w il l be g re a t e r t h a n 0 4 6 0 0 $ / D M s i x m o n t h s f r o m n o w T h ec o m p a n y c o u l d p u r c h a s e a n a p p r o p ri a te a m o u n t o f f o re i g n c u r re n c y c al l o p t i o n s w i t h a n e x e r c t s ep r i c e o f 0 4 6 0 0 $ / D M , i f t h e e x c h a n g e r a t e ra s es a b o v e t h a t l ev e l , t h e a d d i t i o n a l c o s t ( m d o l l a r s )o f t h e h a b ~ h t y p a y m e n t w a l l b e p a n m l l y o f f s e t b y t h e p a y o f f o f t h e c al l o p t i o n s

N o t e t h a t t h e c o m p a n y c o u ld h e d g e e v e n m o r e o f t t s F X n s k b y p u r c h a s i n g ca ll o p t to n s w i t h al o w e r e x e r c is e p ri c e, s a y 0 4 4 0 0 $ / D M ; h o w e v e r , t h e p r ic e o f th i s h e d g e w o u l d b e m o r e c o st ly ,b e c a u s e t h e p r e m i u m f o r t h e o p t i o n s w o u l d b e g r e at e r ( d u e t o th e l o w e r e x e r c is e p n c e ) T h u s ,o n e o f th e i s s u es m F X r is k m a n a g e m e n t - a s w tt h a n y f o rm o f in s u r a n c e p r o t e c t t o n - m v o l v e st h e t r a d e o f f b e t w e e n t h e p r ic e o f t h e h e d g e ( m t h t s c as e , th e o p u o n s ) a n d t h e a m o u n t o f

10p r o t e c t t o n

-) Another alternative wou ld be for the company to sacrifice some potentlal benefit in exchange for protect)on Th lscan be done wlth a combmatlon of puts and calls In thls examp le, the company rmght protect itself by purchasingcall optlons wlth an exercise price of, say, 0 4500 $/DM , but also glve up s om e of the benefit if the $/DM exchangerate falls by selling put optlons with an exercise price of 0 4300 $/DM Note that by dom g this, the company has

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O p t i o n s c a n a l s o b e u s e d t o h e d g e F X r is k w i t h r e s p e c t t o f o r e i g n - d e n o m i n a t e d a s s e t s a n d f u t u r ec a s h i n f l o w s I n t h i s c a s e , t h e c o m p a n y ' s f e a r i s t h a t t h e $ / D M e x c h a n g e r a te w all d e c h n e . T h u s ,t h e c o m p a n y w o u l d p u r c h a s e F X p u t s w l t h a n a p p ro p r ia t e e x e r c m e p n c e , t h u s p ro t e c t i n g t h ed o w n s l d e r i s k

D FXSwapsA s w a p IS a n a g r e e m e n t b e t w e e n t w o c o u n t e r p a r t le s t o s w a p , o r e x c h a n g e , f u t u r e c a s h f l o w s

W i t h r e s p e c t to c u r r e n c y s w a p s , a c c o r d i n g to S m l t h s o n ( 1 9 9 8 ), " T h e e v i d e n c e w e h a v e s e e ns u g g e s t s t h a t t h e d o r m n a n t u s e o f c u r r e n c y s w a p s i s t o m o d i f y t h e n a t u r e o f a d eb t i s s u e A f ir mw i ll b o r r o w i n o n e c u r r e n c y an d u s e a s w a p t o t r a n s f o r m t h e c a s h f l o w s t o a n o t h e r c u rr e n c y . " Ac u r r e n c y s w a p c a n a l s o b e u s e d t o h e d g e F X r i sk o v e r a p e n o d o f t im e , e x c h a n g i n g f ix e d c a s hf l o w s I n o n e c u r r e n c y f o r f ix e d c a s h f l o w s In a n o t h e r A s w a p c a n t h u s m v o l v e t h re e d if f er e n tt y p e s o f c a sh f l o w s a n i n it ia l e x c h a n g e o f p n n c l p a l m t h e t w o d i f fe r e n t d e n o m i n a t i o n s , p er io d i ci n t er e s t p a y m e n t s d e n o m i n a t e d i n dl f f er e n t c u r r e n c i e s p a s s i n g b e t w e e n t h e p a r h e s , a n d f i n al l yt h e r e - e x c h a n g e o f p n n c l p a l a t t h e e n d o f t h e s w a p S w a p s c a n b e t a i l o r- m a d e t o f it a p a r ti c u la rs i t u a t i o n

S e c t io n 5 - S o m e E v i d e n c e R e g a r d i n g H o w I n s u r e r s M a n a g e F X R i s kS e c t i o n s 2 , 3 , an d 4 o f th i s p a p e r h a v e e x a m i n e d t h e n a t u r e o f F X r is k a n d s o m e o f t h et e c h n i q u e s a v a i l a b l e t o m a n a g e t h a t r i s k I n t h i s s e c t i o n , s o m e e v i d e n c e i s p r o v i d e d r e g a r d i n gt h e m a n n e r m w h i c h p r o p e r t y - h a b t h t y i n s u r a n c e c o m p a n i e s h a n d l e s u c h r i s k s i n p r a ct i ce O n e

locked m an exchange rate range of 0 4300 to 0 4500 $/DM Note also that the company, by selling the puts, has

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s ource o f ev tdence i s from a paper (C umm ins , Ph i l l i ps , and Sm i th (1997)) w hich p rov ides as tat is t ical analys is o f f inancm l denv atxves acu vl ty for hfe and property-habfl~ty insurancec o m p a n i e s d u n n g 1 99 4 T h e o t h e r s o u r c e o f e v i d e n c e p r o w d e s a n e c d o ta l r e fo r m a t i o n f o r s e v e r alc o m p a n i e s f r o m t h e i r D e c e m b e r 3 1 , 1 9 9 9 S e c u ri ti e s an d E x c h a n g e C o m m l s s t o n ( S E C ) 1 0 - Kfi l ings

A lnsurerActtvttyDurmg 1994C um mins , P tu lhps , and S mi th (1997) us ed da ta from Schedu le DB o f the 1994 NA IC annuals t a tement s . They co l l ec ted da ta a t the g roup and com pany l ev e l , and the i r f ina l s ample inc ludedov er 2 ,000 prop er ty-h ablh ty insurers (as we l l as ,ov er 1200 li 'fe insurers ) Th ey found that , wi thres pec t to 1994, approx im ate ly 7% ofprope r ty -habf l i ty ins ure r s us ed der iva t ives ; t h is amountedto 142 ins ure r s The y a l s o found tha t la rger com panies w ere more l ike ly to us e der iva t ives thans ma l l e r com pam es For p roper ty -habf l l ty ins urer s, t he mos t o f ten us ed con t rac t s inc ludedfore ign cur r ency fo rwards and equ i ty op t ions .

In par t icular , the authors found that , amo ng prop er ty- l iablh ty insurers , 19 com pam es open edpos~Uons m fo re ign cur r ency fo rwards du nng 1994, and 5 ope ned fo re ign cur r ency s wappos i t ions Four compan ies opened long pos i t ions m fo re ign cur r ency fu tu res , w hi l e 3 openeds hor t fu tu res pos i t rons dunn g 1994 There was s ome , bu t no t muc h , ac t iv i ty in fo re ign cur r encyo p t i o n s d u n n g 1 99 4. W i t h r e g a rd t o th e r e la t iv e l y l a rg e n u m b e r o f c o m p a m e s r e v o l v e d t nfo re ign cur r ency fo rwards , t he au thor s s t a te tha t "T o the ex ten t tha t PC com panies f ace

funded at least som e of the cost of purchasing the call optmns.

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s u b s t a n t ia l f o r e ig n e x c h a n g e e x p o s u r e d u e t o f o r e ig n - b a s e d s u b s l & a n e s a n d / o r t h e h o l d i n g o ff o r e ig n b o n d s o r e q u i ti e s, t t u s r e s u lt i s n o t u n e x p e c t e d "

B A n e c d o t a l E v t d e n c e f r o m l n s u r e r s ' S E C l O - K F t h n g sT h e S E C r e q u i r es a n a n n u a l r e p o rt , k n o w n a s a F o r m 1 0- K, f r o m , a m o n g o t h e r s , e v e r ye x c h a n g e - t r a d e d c o m p a n y . T h e r e p o r t d m c l o se s ce r t a in f i n a n c m l i n f o r m a t i o n i n v o l v i n gr e v e n u e s , i n c o m e , e t c , a n d g e n e r a l l y i n c l u d e s a f m r a m o u n t o f t e x t e x p l a i n i n g v a r io u s f i n a n c m li te m s . F o r m 1 0 - K i s a v m l a b l e as p u b l i c in f o r m a t i o n ; o n e s o u r c e o f a c o m p a n y ' s 1 0- K i s t h eS E C ' s EDGAR d a t a b a s e o f c o r p o r a t e i n f o r m a ti o n . I t

Exc e rp t s f rom a se l e c t i on o f f i ve p ro pe r t y -ha b dl t y i nsure r s a re p rov i de d m Exlub~t 1 The see x c e r p ts s u g g e s t , b a s e d o n t h e c o m p a n i e s ' 1 0 - K f i h n g s , t h e n a tu r e o f t h e i r f o re i g n e x c h a n g e r a t en s k a n d h o w t h e y m a n a g e t h a t n s k A l l 1 0 - K f il in g s r e f e r en c e d h e r e w e r e b a s e d u p o n t h ec o m p a n i e s ' D e c e m b e r 3 1 , 1 9 9 9 f i n a n c ia l s t a te m e n t s T h e v a r i o u s ex c e r p t s sp e c i f ic a l ly m e n t i o nt h e u s e o f f o r w a r d c o n t r a c ts , s w a p s , a n d a s s e t - l, a b d l t y m a t c h i n g a s a p p r o a c h e s e m p l o y e d f o rh e d g i n g F X n s k

S e c t i o n 6 - M o d e l i n g F o r e i gn E x c h a n g e R a t e sUl t i ma t e l y , i nsure r s wa nt t o be a b l e t o mod e l a nd qu a n t i fy FX r i sks i n o rde r t o a s se s s a l t e rna t i vem u l t i n a t i o n a l f in a n c i n g a n d o p e r a t i n g p o li c ie s . T h e r e a r c a n y n u m b e r o f a p p r o a c h e s t o F X r a t ef o r e ca s ti n g , i n c l u d i n g a v a r i e ty o f s o p h i s t ic a t e d m a c r o e c o n o m l c m o d e l s . A n o t h e r i n t e r e s ti n g a n d

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r e c e n t a p p r o a c h i s d o c u m e n t e d m D e G r a u w e , e t a l ( 1 9 9 3 ), m w h i c h t h e a u t h o r s a p p l y c h a o st h e o r y t o t h e t a s k o f m o d e h n g e x c h a n g e ra t es ( C h a o s t h e o r y c a n be u s e f u l i n m o d e l i n gp r o c e s s e s t h a t e x h i b i t c o m p l e x i t i e s a n d n o n - h n e a n t ~ e s ) H o w e v e r , a l l o f t h e s e t e c h n i q u e s a r eb e y o n d t h e s c o p e o f t h i s p a p e r , s e v e r a l r e l e v a n t c t t a t l o n s a r e p r o v i d e d t n t h e R e f e r e n c e s e c t i o n

I n th ~s s e c t m n , t h e e m e r g e n c e o f f o r e ig n e x c h a n g e r a t e s o v e r t~ m e t s c o n s t d e r e d f r o m a m o d e h n gp e r s p e c t i v e , i t m a y b e u s e f u l to p l a c e t h i s e f f o r t w i t h i n a f a m d i a r a c t u a ri a l c o n t e x t , d y n a m i cf i n a n c m l a n a l y s i s F t rs t, F X f o r e c a s t in g i s b r i e fl y e x a m i n e d a s a n a p p h c a t i o n o f s t o c h a st i cp r o c e s s t h e o r y N e x t , t h e d i f f ic u l t ie s o f s u c h a n a p p r o a c h - r e v o l v i n g a r o u n d t h e n e e d toa p p r o p r i a t e l y m o d e l c e r t a i n c o r r e l a t m n s a n d r e l a t io n s h ~ p s w ~ t h o t h e r f i n a n c t a l v a r i a b l e s - a r ec o n s~ d d re d F i n a ll y , s o m e o th e r c o n s ~ d e r a u o n s r e g a r d i n g f o re i g n e x c h a n g e ra t e m o d e h n g a r ep r e s e n t e d

A F X R a t e s a s a S t o c h a s t t c P r o c e s s

L o o k i n g a t t h e a c c o m p a n ) q n g c h a r t s s h o w i n g t h e t~ m e s e r i e s o f F X r a te s , o n e m ~ g h t r e c o g n iz et h e g e n e r a l " p a t te r n " e s s e n ti a l ly , t h e s e ti m e s e r ie s a p p ea r t o h a v e a " r a n d o m w a l k " a p p e a r a n c et h at o n e o f t e n a s s o c m t e s w ~ th s to c k p r i c e m o v e m e n t s , i n t e re s t ra t e s, a n d s o m e o t h e r f i n a n c ia l a n de c o n o m t c p r o c e s s e s . A f a ir a m o u n t o f e f fo r t h a s b e e n e x p e n d e d m t r3 a n g t o m o d e l a n d f o r e c a s tf o r e ig n e x c h a n g e r a te s H o w e v e r , a s m e n t i o n e d m D e G r a u w e , e t a l ( 1 9 9 3 ) , " S i n c e t h e r e c e p ti o no f f l o a t in g e x c h a n g e r a t e s m t h e b e g i n n i n g o f t h e 1 9 7 0 s , e c o n o m i s t s h a v e a t t e m p t e d t o d e v e l o pt h e o r ie s t h a t e x p l a i n e d w h a t w a s g o i n g o n , a n d t h a t c o u l d b e u s e d t o m a k e p r e d i c t i o n s a b o u tf u tu r e e x c h a n g e r at e m o v e m e n t s A f t e r a l m o s t t w e n t y y e a r s o f f r e n et ic r e s e a r c h o n e ~ s f o r ce d t o

t a All of the 10-K excerpts m this paper were de nved from the ED GAR database, w luch is accesssble from the

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admit that success has been hml te d" Rosenberg (1996) comments that "the ewdence suggeststhat at short- and medium-term horizons, a random walk characterizes exchange rate movementsbetter than most convent,onal fundamental-based exchange rate mo de ls "

A s~gn~ficant trend m the property-hablhty insurance industry is the development andimplementation, largely by actuaries, of dynamic financial analysis (DFA) models Thesemodels incorporate simulation techniques involving a variety of financial, economic, andinsurance processes - e g, interest rates, equity market returns, insurance losses, etc If acompany has significant multinational operations or investments and is exposed to FX risk, theDFA model should also include a foreign exchange process.

Expanding upon recent DFA-related work on stochasttc interest rate modeling (and interest ratescertainly have an important relationship to foreign exchange rates, as discussed below), FX ratescan be viewed as a geometric Brownlan motion process evolwng over time

dS=laSdt + aSdZ

where S is the spot rate of foreign exchange, p ~s the rate of change (the "draft") m the spot rate, tis time, O'lS the volat lhty factor associated with movements m the spot rate, and dZ ~s a Wiener(or simple random walk) process In this framework, instantaneous movements m the foreignexchange spot rate through time are a function of a deterministic drift component (whLch mzghtbe mean-reverting) and a stochastic volatlhty component that introduces vanablhty to the

SEC' s websl te a t www sec g o v

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process This geometric Browman mot ion specification of the spot rate would imply that futurevalues o.f the spot rate have a Iognormal distribution

Examples of mean-reverting financial models can be found in the interest rate model ingliterature For mstance, in D'Arcy, et al (1997 and 1998), the Cox-Ingersol l-Ross (1985) model(the CIR model) of s tochasuc interest rates Is employed as the basis for the simulation o f futureinterest rates Specifically, this model is characterized by the following equation

dr=tc(O-r)dt + ffrS dZ

where r Is the (short-term) interest rate, h-is the rate of mean reversion, and Ois the long-runmean value of r Thus, the CIR model ts a mean-reverting model in which the volatility of theprocess is proportional to the square root o f the interest rate level (meaning that there is greatervolatility associated with higher interest rates, and vice versa) This mean-reverting frameworkcould also be used for foreign exchange rates, if the data suggested that It was appropnate. Onthe other hand, the exponent on the r m the second term could be changed based on indicationsm the data - for example, if such volatlhty proportlonahty is not considered appropriate, theexponent could be changed to zero

Once alternative specfficatlons for the FX rate process are considered and a particular model isselected, a discrete-time version can be developed which provides the basis for slmulahon. Forexample, suppose that the general geometric Browruan motion specification described above is

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u s e d f o r t h e s p o t e x c h a n g e r a te . A d i s c r e t e - ti m e v e r s i o n o f t h e f o r m u l a t h a t c o u ld b e u s e d f o rs i m u l a t i o n ( s e e , f o r e x a m p l e , H u l l ( 2 0 0 0 ) ) w o u l d b e '

A S = # S A t + ~ r S e (A t ) 5

w h e r e e w o u l d b e a r a n d o m l y s e l e c t e d v a l u e f ro m a s t a n d a r d n o r m a l d l s t n b u t t o n T h u s , m aD F A m o d e l , f o r e x a m p l e , f u t u re i n c r e m e n t s o f t i m e - e g , m o n t h s o r y e a rs - w o u l d d e f i n e th e A t

t e r m , a n d t h e d i s c r e t e c h a n g e m t h e s p o t r a te o v e r t h a t p e r i o d o f t ri n e w o u l d b e e q u a l t o t h e s u mo f a n o n - s t o c h a s t i c te r m a n d a s t o c h a s t i c te r m w h i c h w o u l d b e s i m u l a t e d

C o n c e p t u a l l y , m o d e h n g F X r a t e e m e r g e n c e a s a s t o c h a s t ic p r o c e s s a s d e s c r i b e d a b o v e i ss t r a i g h t f o r w a r d H o w e v e r , t h e r e a re a t l e a s t t h r e e c h a l l e n g i n g ~ s su e s r e v o l v e d m t h~ s t y p e o fm o d e l i n g . ( 1 ) d e t e r m m m g t h e a p p r o p n a t e m o d e l s p e c i fi c a ti o n ( e g , m e a n - r e v e r t in g ?p r o p o r t i o n a l v o la t l h ty 9 ) , ( 2 ) e s ti m a t i n g th e p a r a m e t e r s o f t h e m o d e l , a n d ( 3 ) re c o g r u z m g th ec o r r e l a t io n s a n d r e l a t l o n s f u p s w i t h o t h e r f i n a n c m l a n d e c o n o m i c v a r i ab l e s. T h e f ir s t t w o i s s u e sa r e st a ti s ti c a l a n d e c o n o m e t n c m a t t e rs t h at a re b e y o n d t h e s c o p e o f t f u s p a p e r T h e t h ir d z ss u e i sa d d r e s s e d m t h e f o l l o w i n g s e c t io n .

B Correlattons and Relattonshtps w, h Other VariablesF o r e i g n e x c h a n g e r a t e s a r e p o t e n t m l l y r e l a te d t o a v a r i e ty o f o t h e r f in a n cx a l a n d e c o n o m i cv a r i a b l e s m t h e r e le v a n t c o u n t r i e s. A n y D F A - t y p e m o d e h n g s y s t e m , w h e n f o r e c a s t i n g p o s s i b l ef u t u re p a t h s o f e x c h a n g e r a t e s , w all n e e d t o a p p r o p r i a te l y c o r r e la t e F X r a t e s w i t h t h e s e o t h e rf i n a n c i a l v a r i a b l e s I n p a r tx c u l ar , t h e r e e x i s t s a s e r i e s o f h y p o t h e s i z e d r e l a t l o n s l u p s r e v o l v i n g

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t w o c o u n t n e s ' i n t e re s t r a te s , m f l a t m n r a te s , a n d f o r e i g n e x c h a n g e r a t e s. ( T h e s e r e l a t io n s h i p s ar eg e n e r a ll y c ri ti c al m m a c r o e c o n o m l c m o d e l s o f e x c h a n g e r a te s )

T h e f i r s t r e l a tm n s h ~ p ~ s r e f e r r e d t o a s interest ratepanty T h e m a t h e m a t ic a l d e f i n m o n o f in t er e str a t e p a n t y ~ s

o r

l+rF = f F l u1 + r u S t 1 u

s ~ , . 0 + r . ) = ( l + r . ) f . , .

w h e r e S is t h e s p o t e x c h a n g e r a t e a n d f l s f o r w a r d e x c h a n g e r at e (b o t h e x p r e s s e d a s f o r e i g nc u r r e n c y u m t s p e r U S d o l la r ) , F a n d U a r e s u b s c r i p t s d e n o t i n g t h e f o r e i g n c o u n t r y a n d t h e U S . ,r e s p e c t w e l y , a n d r I s t h e i n t e r e s t r a t e ( m t h e c o u n t r y i d e n t i f i e d b y t h e s u b s c r i p t ) . I n t e r e s t r a t ep a n t y t h u s r e q m r e s t h a t e q u a l r e t u r n s b e g e n e r a t e d m t w o d i f f e r e n t c u r r e n c t e s w h e n t h e e x p e c t e dc h a n g e m t h e e x c h a n g e r a t e i s t a k e n i n to a c c o u n t T h~ s m a y b e c l e a r e s t f r o m t h e s e c o n d f o r m u l aa b o v e w h e t h e r o n e c o n v e r t s to t h e f o r e i g n c u r r e n c y a n d t h e n i n v e s t s at th e f o r e tg n i n te r e s t r a te ,o r i n v e s t s m t h e U . S a n d l a te r c o n v e r t s at t h e o ri g in a l f o r w a r d r a t e , s h o u l d n o t m a t t e r o n a ne x p e c t e d b as ~ s ( t o t h e e x t e n t t h a t t h e f o r w a r d r a t e r e p r e s e n t s a n e x p e c t a t m n r e g a r d i n g t h e f u t u r es p o t r a t e ).

A n o t h e r ~ m p o r t a n t r e l a t i o n s h i p i s r e f e r r e d t o a s purchasmg power pant y ( s o m e t t m e s c a ll e d th e" l a w o f o n e p r ic e " )

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f F / u = E [ l + : e ]S ~ u E l i + l u ]

w h e r e t i s t h e i n f la t io n r a te m t h e s u b s c n p t e d c o u n tr y . T h u s , p u r c h a s i n g p o w e r p a n t y s a y s t h ate x p e c t e d c h a n g e s i n t h e e x c h a n g e r a t e a r e a f u n c t io n o f e x p e c t e d & ff e r e n c e s m t h e c o u n t r i e s 'i n f la t io n r a te s T h i s ~ m p ll es t h a t a g o o d s h o u l d c o s t t h e s a m e r e g a r d l e s s o f t h e c o u n t ry m w h i c hi t ~s b o u g h t ( a f t e r a d j u s t m e n t , o f c o u r s e , f o r t h e e x c h a n g e r a t e )

A t h i rd r e l a t i o n s h i p i s c a l l e d t h e m t e r n a t w n a l F i s h e r e ff ec t.

l + r r = E [ l + ' r ]l + r U E [ l + t v ]

T h e m t e r n a t m n a l F i s h e r e f f e c t s ta t e s t h a t c h f f e r e n c e s i n ( n o n u n a l ) i n t e r e s t r a t e s a r e a f u n c t i o n o f& f f e r e n c e s i n th e c o u n t r i e s ' e x p e c t & i m f l a t m n r a t e s T h~ s t s a n m t e m a t ~ o n a l v e r s io n o f th eF ~ s h e r e f f e c t , w h i c h s a y s t h a t a n o m i n a l m t e r e s t r a te ~ s a c o m b l n a t m n o f a re a l i n t e r e s t r a te a n da n m f l a t m n r a t e.

A n y o n e m o d e h n g e x c h a n g e r a te s n e e d s t o d e c i d e t h e e x t e n t t o w h i c h e a c h o f t h e s e re la t~ o ns l' up sw a ll b e c o n d i t i o n s i n c o r p o r a t e d in t o th e m o d e l T h i s m a y b e a f u n c t i o n o f th e t i m e h o r i z o nr e v o l v e d m t h e m o d e l ' s f o r e c a s t s ( f o r e x a m p l e , a n d h y p o t h e t i c a l l y , ~ f lt ~s b e l i e v e d t h a t t h e r e c a nb e s h o r t - t e r m v a r i a t io n s f r o m o n e o r m o r e o f t h e se r u le s , b u t th a t t h e r u le s p r o w d e a r e a s o n a b l ea p p r o a c h to d e t e r m i n i n g e q u d l b n u m m t h e l o n g e r- r u n ) I n c o r p o r a t io n o f t h e s e r e l a tl o n s l u p s i si m p o r t a n t, b u t c a n b e c o m p h c a t l n g F o r e x a m p l e , i t w o u l d b e c o n c e p t u a l l y s t r a ig h t f o r w a r d t oa p p l y a B r o w m a n m o t i o n p r o c e s s m t h e s lm u l a t m n o f F X r a t e s . H o w e v e r , m a b r o a d - b a s e d (s a y,

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D F A ) m o d e l , t h e i n t e r e s t r a te s a n d i n f l a t io n r a te s i n t h e v a r i o u s c o u n t r i e s m ~ g h t a l s o b e s i m u l a t e ds e p a r a te l y , u s i n g s i m d a r s t o c h a s t i c p ro c e s s t e c h m q u e s . C a r e m u s t b e t a k e n t o p r o p e r l y i n t r o d u c ei n t o t h e m o d e l t h e c o r r e l a t m n s b e t w e e n c o n c u r r e n t m o v e m e n t s m a l l t h e s e p r o c e s s e s . ( S e e , fo re x a m p l e, v a n D e v e n t e r a n d I m a i ( 1 9 9 7 ) )

C O t h e r F X l s s u e s R e le v a n t t o M o d e h n gA s t o c h a s t i c f o re i g n e x c h a n g e r a t e m o d e l s h o u l d a l s o c o n t e m p l a t e t h e d i f f e re n t a p p r o a c h e s t of or ex g n ex ch an g e r e l a t io n sh ap s th a t ex i s t m d i f f e r en t co u n t r i e s Fo r ex am p le , t h e I n te r n a tx o n a lM o n e t a r y F u n d c l as s x fi e s c o u n t r i e s ' p o h c i e s a s s o c m t e d w i t h e x c h a n g e r a t e s a c c o r d m g t o s e v e r a la l t e m a t a v e c a t e g o r ie s ( s e e , f o r e x a m p l e , S h o u p ( 1 9 9 8 ) a n d M a n g e ( 2 0 0 0 ) ):

P e g g e d " m a i n t a i n s a f i x ed v a l u e r e l at x o n sh l p , e i t h e r w i t h a n o t h e r s i n g l e c u r r e n c y o r w i t ha c o m p o s i t e c u r r e n c y.

L t m t t e d f l e x t b t h t y " a l l o w s t h e r a t e t o f o a t w i t h i n a r e l a t iv e l y n a r r o w r a n g e ( e xt h er r e l a ti v et o a s i n g l e c u r r e n c y o r t h r o u g h a c o o p e r a t i v e a g r e e m e n t )

G r e a t e r f l e x t & h t y " a l lo w s th e r a t e to f lo a t wx th m a r e l a t iv e ly wid e r an g e . F l o a t i n d e p e n d e n t ly " a l l o w s t h e r a t e t o f l o a t a c c o r d in g t o t h e m a r k e t

A q u e s t i o n a s s o c m t e d w i t h t h e s e e x c h a n g e r a t e " r e g i m e s " i n v o l v e s h o w c o n s i s t e n t l y a n d r e h a b l ya c o u n t r y a p p h e s R s o w n p o h c l e s . T h e s e I s s ue s s h o u l d b e c o n s i d e r e d w h e n m o d e l i n g f o r e ig ne x c h a n g e r a te s .

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S e c t io n 7 - S u m m a r y , a n d C o n c l u s io nA s t h e p r o p e r t y - h a b t h t y i n s u r a n c e i n d u s t r y b e c o m e s i n c r e a s i n g l y g l o b a l , c o m p a n i e s w i t hm u l t l n a h o n a l o p e r a t io n s a n d / o r i n v e s t m e n t s w i l l p o t e n t i a l ly b e e x p o s e d t o s l g n t f i c a n t f o r ei g ne x c h a n g e r a te ri s k T h i s p a p e r h a s e x a r m n e d t h e s o u r c e s o f s u c h n s k , & s c u s s e d t h e i n st i tu t i o n a lt e c h m q u e s a v m l a b l e to c o m p a m e s t o m a n a g e t h a t r is k , a n d p r o v i d e d e v i d e n c e r e g a r d i n g th e r ~s km a n a g e m e n t t e c h n i q u e s a c t u a l l y b e i n g u ti l iz e d b y t h e i n d us t ry . T h e p a p e r a l s o b r i e f l y p r e s e n t e ds o m e p o s s t h l e a p p r o a c h e s t o m o d e h n g ( f o r e x a m p l e , i n a d y n a m i c f i n a n c i a l a n a l y s i s f r a m e w o r k )f o r e i g n e x c h a n g e ri s k W h e n m o d e h n g , t h e i n t e r r e la t l o n s h l p s b e t w e e n e x c h a n g e r a t e s a n d o t h e rv a r i a b l e s - e g ., i n t e r e s t r a t e s a n d r o t a t i o n r a t e s m t h e r e l e v a n t c o u n t r i e s - m u s t b e c o n s i d e r e dand r e f l ec ted .

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R e f e r e n c e s

Campbell and Kracaw, 1993, Folancta[ Risk Management Fixed h~come and ForeignExchange, Ha rperCo lhns Co llege Publishers , New Yo rkCox, Ingersoll, and Ross, 1985, "A T heo ry o f the Term Structure o f Interest Rates,"Econometrtca, 53 385-407Cum mins, Ph tlhps, and Smith, 1997, "C orp orate Hedging m the Insurance Industry Th e Use o fFinancial D erivatives b y Insurers," North American Actuarial Journal, I (1) 13-40D 'Arc y, Gorvett , Herbers , Het tmger , Lehmann, and M iller, 1997, "Bu ilding a Pubhc Acc ess PC-Based DF A Mo del , " Dynamic Financial Analysts Call Paper Program, Cas ual ty A ctuarialSociety, pp 1-4 0D 'Ar cy , Gorvett , Hettmger , and Walhng, 1998, "U sing the Pub hc-A ccess D FA Mod el A CaseStudy ," Dynamic Financial Analysts Call Paper Program, Casua l ty Actuar ia l Soc ie ty , pp 53-118De Grauwe, Dewachter, and Embrechts, 1993, Exchange Rate Theory ChaoticModels ofForeign Exchange Markets, Blackwell Pubhshers, OxfordHull, 2000, Opttons, Futures, and Other Derivatives, Prentice Hall , Up per Sad dle River , NJKolb, 1996, Financial Derivatives, Blackwell Publishers, Inc, Cambridge, MAMange, 2000, "Measuring Foreign Exchange Risk m Insurance Transactions," North AmericanActuarial Journal, 4(2) 88-100Rosenberg, 1996, Currency Forecasting A Guide to Fundamental and Techmcal Models ofExchange Rate Determmatton, Irwin Professional Pubhshlng, Chicago, ILShoup, 1998, The International Guide to Foreign Currency Management, A M A C O M , A m e r ic anManagement Assoc ia t ion , New YorkSmlthson, 1998, Managing Financial Risk A Guide to Derivative Products, FinancialEngineering, and Value Maximization, McG raw-Hill , New Y orkVan D eventer and Imai , 1997, Financial Rtsk Analytzcs: A Term Structure Model Approach forBanking, Insurance and Investment Management, Irwin Professional Publishing, Chicago

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E x h i b i t 1E x c e r p t s f r o m S E C 1 0 - K F i li n g s

S o u r c e E D G A R D a ta b a s e, S E C w eb s~ te(0 CNA Fmanctal Corp" F o r e i g n e x c h a n g e r a te r is k a r is e s f ro m t h e p o s s l b d l t y t h a t c h a n g e s m f o r e ig n c u r r e n c ye x c h a n g e r a te s w i ll i m p a c t t h e v a l u e o f f in a n c m l i n s t r u m e n t s T h e C o m p a n y h a s f o r ei g ne x c h a n g e r a t e e x p o s u r e w h e n ~t b u y s o r s e l l s fo r e i g n c u r r e n c i e s o r f i n a n c m l i n s t r u m e n t sd e n o m i n a t e d m a f o r e ig n c u r r e n c y . . T h a s e x p o s u r e ~s m m g a t e d b y th e C o m p a n y ' s a s s e t / h a b d l t ym a t c h i n g s t r a te g y a n d t h r o u g h t h e u s e o f f o r w a r d c o n t r a c ts f o rt h o s e i n s t r u m e n t s th a t a r e n o t m a t c h e d " "

O0 CIGNA Corp" C I G N A ' s i n v e s t m e n t s t r a te g y ~s t o m a n a g e t h e c h a r a c t e n s u c s o f i n v e s t m e n t a s se t s , s u c h a sh q m d ~ t y , c u r r e n c y , y i e l d a n d d u r a t i o n , t o r e f l e c t t h e u n d e r l y i n g c h a r a c t e r i s t i c s o f t h e r e la t e di n s u r a n c e a n d c o n t r a c t -h o l d e r h a b d tt ~ es , w h i c h v a r y a m o n g C I G N A ' s p n n c l p a l p r o d u c t h n e s I nc o n n e c t i o n w ~ th th ~ s i n v e s t m e n t s tr a te g y , C I G N A u s e s d e r i v a ti v e i n s t r u m e n t s th r o u g h h e d g i n ga p p h c a U o n s to m a n a g e m a r k e t r i s k . ." C u r r e n c y s w a p s a r e u s e d t o m a t c h t h e c u r r e n c y o f m & v i d u a l i n v e s t m e n t s t o th a t o f t h ea s s o c i a t e d h a b d m e s" C a s h r e q m r e m e n t s a r is e a s a r e s u lt o f C I G N A ' s d e r i v a ti v e a c tw ~ t le s U n d e r c u r r e n c ys w a p s , t h e p a r t ie s g e n e r a l l y e x c h a n g e a p n n c x p a l a m o u n t m t h e t w o r e l e v a n t c u r r e n c i e s, a g r e e i n gt o r e - e x c h a n g e p n n c ~ p a l a m o u n t s a t a s p e c i f ie d f u tu r e d a te u s i n g a n a g r e e d - u p o n e x c h a n g e r a te ,a n d a g r e e i n g to p e n o & c a l l y e x c h a n g e a m o u n t s e q u a l to m t e r es t p a y m e n t s u s i n g t h e ag r e e d -u p o ne x c h a n g e r a t e "

Ou) The St Paul Compames, lnc" O u r e x p o s u r e t o m a r k e t r i s k f o r c h a n g e s i n f o r e ig n e x c h a n g e r a te s ~ s c o n c e n t r a t e d m o u ri n v e s t e d a s s e t s d e n o m i n a t e d m f o r e ig n c u r r e n c ie s C a s h f l o w s f r o m o u r f o r e i g n o p e r a t i o n s a ret h e p r i m a r y s o u r c e o f f u n d s f o r o u r p u r c h a s e o f t h es e i n v e s t m e n t s W e p u r c h a s e t h e s em v e s t m e n t s p r i m a r i l y t o h e d g e i n s u r a n c e r e s e rv e s a n d o t h e r Il ab a h tt es d e n o m m a t e d m t h e s a m ec u r r e n c y , e ff e c t iv e l y r e d u c i n g o u r f o r e ig n c u r r e n c y e x c h a n g e ra t e e x p o s u r e "

According to tts 10-K, CNA also performed sensmvlty analyses with respect to interest rate risk, eqm ty price risk,and forexgncurrency exchange rate r isk The tmpact of I0% and 20% changes m foreign currency exchange rateswere esmna ted

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Exhibit I (cont.)Excerpts fro m SEC 10-K Filings

Source EDGAR Database, SEC webslteOv) Pro gress tve Corporation"Denvauve instruments, as defined by Statement of Fmancml Accounting Standards (SFAS)119, "Disclosures about Denvatlve Financial Instruments and Fmr Value of FmancmlInstruments," include futures, options, short posmons, forward posmons, foreign currencyforwards and interest rate swap agr ee me nt s. . Hedges are evaluated on estabhshed criteria todetermme the effectiveness of their correlation and ablhty to reduce risk o f specific securities ortransactions"

(v) Chubb Corp"The Group's overseas busmess is developed by its foreign agents and brokers through localbranch offices of the Group and by its Umted States and Canadian agents and brokers Inconducting ItS overseas business, the Group reduces the nsks relating to currency fluctuanons bymamtmnmg investments m those foreign eurrencms in winch the Group transacts business, wHhcharacteristics slmdar to the habflmes m those currencies The net asset or liability exposure tothe various foreign currencies is regularly rewewed"Foreign currency risk is the senslhwty to foreign exchange rate fluctuations of the market valueand investment mcome related to foreign currency denominated financial instruments Theftmcuonal currency of our foreign operations is generally the currency of the local operatingenvironment since their business is primarily transacted m such local currency We reduce therisks relating to currency fluctuations by mmntalnlng investments m those foreign currencies mwhich we have loss reserves and other habditles. Such inves tments have characteristics similar toour liainlmes m those currencies... ."

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Chart ITime Series of Mombly Exchange Rstes

B n t t s b Poand / U S Dollar(Data per FRED, St Louts F~)

0 9O80 7~ '

~ o ,030201

Mon~

C h a r t I AT i m e S e n e s o f M ~ t h l y F I rs l d T e r en c e s o f E x c h a n g e R a t e s

BnlL1h Po unds / U S. DolLars(Data per FR ED , St Louts FRB )

O O B

M m ~

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C h a r t I BTime Ser ies of Monlhly Percenlage Changes in Exchange Rates

Br l l lsh Pounds / U S, Dollars(Data per FRED , S| Lou;s FRB)

i ! M~thChart 2Time ~n e s or '~ lootbly Exchange Rates

French FraQc / U S Dol lar(Data per FRED, SI LOULSFRB)

e! ,J

4

20

5 [


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4 .

353

252

' i0 5

0

C h r t 3T i m e S e r ~ s o f M o n t h l y E x c h l n g e R a t e s

G e r m a n M a r k s / U . $ , D o l la r(Data pe~ FRED , S t L o u ~ F R B )

Mona

C h a r t 4T t m e S e r i e s o f M o n t h l y E z c h l n g e R a t ~

J t p a n c ~ e Y e n / U . S . D o ~ ht r(Dam pe r F RE D, S I Lou ts F RB )

25O

150100

o

Foreign Exch Risk Instntl Issues & Modeling

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