Academic journal article International Journal of Business

Relevance of Currency Exposure in the Valuation of Single-Country Closed-End Funds

Academic journal article International Journal of Business

Relevance of Currency Exposure in the Valuation of Single-Country Closed-End Funds

Article excerpt

ABSTRACT

The relevance of currency translation exposure on the valuation of single country closed end funds (SCCEFs) is examined, using net asset values (NAVs) and market prices of these funds--the two prices closed end funds have. Given differential information holding hypothesis, the size of assets and liabilities of closed end funds, and the method of computing net asset value, it is anticipated that changes in exchange rates will quickly be observed in the net asset values, and thereby influence the volatility of discounts or premiums of these funds. This study particularly focuses on daily movements of exchange rates, market prices and net asset values.

JEL: G150, F310

Keywords: Currency exposure; Currency crisis; Closed-end funds; Net asst vale (NAV); Hedge

I. CURRENCY EXPOSURE

Currency exposure and the attendant risk on receivables, payables, revenues and costs as a result of change in exchange rates are unavoidable events that corporations have to learn to live with. The decision on how to manage the currency exposure depends on the management philosophy of each corporation, the level and types of exposure. To hedge or not to hedge transaction exposure revolves, among others, on the amount of net exposure, the volatility of the currency and the availability of instruments for hedging purposes. Economic exposure because of its long-term nature needs structural changes to influence inflows (revenues) and outflows (costs) to reduce the impact of changes in exchange rates. Survival and growth particularly of multinational corporations are linked on how effectively these two types of exposure are managed. However, when it comes to translation exposure the juries (academics and practitioners) are still out on its impact in the valuation of corporations. FASB#8 in earlier years and FASB#52 since 1980s have dealt with the issue of translation exposure and promulgated on how to recognize, adjust and report translation gains or losses in consolidated financial statements. The issue at hand is whether to hedge or not to hedge translation (or as some call it accounting) exposure. Translation exposure occurs when multinational corporations reinstate and translate their foreign subsidiaries financial statements and incorporate them in their consolidated financial statements. This accounting exercise is to report to the public an overall picture of the health of multinational corporations. It does not affect the cash inflows or outflows and as such it is strongly argued in some quarter that it is a paper or accounting exposure and irrelevant to take a costly hedging position. Others argue the translation gain or loss is included in the financial statement and the investing public may use it in the valuation of corporation and therefore translation exposure need to be hedged. In general the majority of the practitioners side on the irrelevance of translation exposure, as seen in their SEC filings, when it comes to the valuation of stock prices of corporations. This study argues the preeminence of translation exposure in the valuation of single country closed end funds (SCCEF) both in the determination of market prices and NAVs.

II. DISCOUNTS AND PREMIUMS IN SCCEFS

The study by Lee, Schleifer, and Thaler (1990) states that SCCEFs are populated by two types of investors: rational and noise investors. Unlike rational investors, noise traders' expectations about asset returns are partly influenced by their sentiments, which cause overestimation on asset return at some times and underestimation at other times. It is reasoned that noise traders' overestimation and underestimation on returns are unpredictable in the eyes of the rational investors. Since the emotion-charged estimations tend to be correlated across noise traders, it is hard to deal with their estimates. As a result, the closed-end funds, which are largely comprised of individual investors, are subject to the systematic risk of such noise traders' sentiments. …

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