Asset Value Correlation Bounds for Firms with Foreign Exchange Exposure

Abstract

This article explores asset correlation estimation among firms with foreign exchange exposure. In most credit risk models, the exchange rate risk is ignored—that is, the borrowing firms are supposed to have assets denominated in the same currency as their debt. In reality, this scenario is often not the case, and if two borrowers’ asset portfolios are exposed to foreign exchange risk, the correlation between these asset portfolios will be biased upward. The size of the asset value correlation bias depends on the time-series behavior of the two borrowers’ asset values, and an empirical assessment of the size of this bias is therefore nontrivial because the asset values of the borrowers are not observable. In this article, using a new way of estimating asset values, we attempt to estimate this bias for a set of major S&P 500 firms in various industries. Our empirical findings support the theory, and we find typical asset correlation estimates ignoring the exchange rate risk to be significantly biased. We therefore suggest that risk managers compute upper and lower bounds to the asset correlation estimates as a matter of routine, and that if the exact asset correlation is required, it is estimated through a careful assessment of the borrowing firms’ foreign exchange exposure.

TOPICS: Fixed income and structured finance, risk management, fixed-income portfolio management