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The Effect Of Exchange Rate Changes On Hedge Funds' Net Asset Value

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I. Introduction

According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits. The economic theories that link exchange rates, price levels, and interest rates together are called international parity conditions. According to the uncovered interest rate parity (UIP), the difference in interest rates between two countries reflects the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency. According to this parity condition, one can't, on average, profit from speculating on this interest rate differential.

Puzzling however, investors seem to exploit the interest rate differential substantially, the so called carry trade. There is no generally accepted definition of what constitutes a carry trade. We define a carry trade as taking a short position in a low-interest-rate currency (funding currency) and a long position in a high(er)-interest-rate currency (target currency). Although the UIP tells us that carry trades yield no predictable profits. However, carry trades are shown to be profitable by Meese and Rogoff (1983). The authors explain that the best predictor of next month's exchange rate is today's exchange rate, which is evidence against the UIP. Even more striking, researchers (Burnside, et al, 2006) have found high-interest-rate currencies tend to appreciate against low-interest-rate currencies over short and medium time horizons, making it profitable to engage in carry trading. Carry trades do involve exchange rate risk, which should be taken into consideration. If the target currency depreciates against the funding currency before the end of a loan contract, the value of the amount initially borrowed in the funding currency will increase in terms of the target currency. This increases borrowing costs which ultimately leads to lower profitability or even losses. Therefore, exchange rate volatility is an important factor in deciding whether or not to engage in carry trading (or to what extent). ECB president Trichet recently warned that recent low levels of volatility may have lulled traders into a false sense of security about the risk and return of the carry trade.

Hedge funds (although widely differentiated) view carry trades as part of a broad spectrum of liquid investments and therefore use it to optimize their portfolios with respect to exchange rate exposure. We would not expect carry trades to be profitable using the Dollar and the Euro as funding and target currency since European and U.S. interest rates have been relatively similar over the past 20 years. The historically low levels of interest rates in Japan and the more or less proven profitability of carry trades may well have led to hedge funds taking large short positions in the Japanese Yen and long positions in a currency like the Dollar. Unfortunately, evidence on the magnitudes is fairly limited, but preliminary studies show the significance of carry trades. This implies that (carry trading) hedge funds' profits are exposed to currency risk, in the sense that an appreciating Yen will lead to lower profitability. Changes in exchange rates do not need to have an effect on expected profitability or market value, as long as the changes are expected. However, unexpected changes in the exchange rate will have an effect on expected profitability and these changes should therefore be reflected in the hedge funds' market value. In this paper we examine the relationship between the net asset value of hedge funds and changes in the exchange rate of the Yen with respect to the Dollar. Although hedge funds will differ in their short and long positions, their net asset value will be affected by the Yen exchange rate in much the same way due to the fact that carry trades can be considered a one way road . Therefore, we are expecting to find a positive relationship between net asset value and the Yen exchange rate. This effect will be more pronounced, the larger the carry trades, but will not be influenced by expectations since we are regressing on net asset value and not on market value. Analyzing the relationship between net asset value and the Yen exchange rate will tell us something about the amount of carry trading but will, unfortunately, not enclose any information on investors expectations of future exchange rates.

The following section will give a brief overview on the earlier studies. Section III will describe our model which is more or less extracted from Donnely and Sheehy (1996). In section IV we describe our empirical findings followed by several concluding remarks.

II. Literature Review

Previous studies that are relevant to our research have, most likely due to a lack of detailed data, either concentrated on hedge fund behavior concerning carry trades or the overall amount of carry trades executed in Yen. Both research areas are relevant to our paper and therefore discussed below. Another breach of literature that is highly relevant is the literature, which addresses the issue of influence of exchange rates on stock prices. Donnelly and Sheehy (1996) analyze the effect of movements in the Sterling exchange rate on the share price of U.K. exporters. The authors are dealing with stock prices and could therefore discuss the role of exchange rate expectations but leave this, unfortunately and for no obvious reason, completely unaddressed. The selected firms used in their regression are U.K. firms that at least sold 40% of total production to other countries in order to obtain a sample group that was exposed to exchange rate movements in a predictable fashion. The authors do indeed find the regression results as predicted, although with a model without too much explanatory power.

Although hedge funds have highly diversified strategies, they may be exposed to exchange rate movements in a predictable way too. As mentioned above, the historically low levels of interest rates in Japan, may well have led to hedge funds taking short positions in the Japanese Yen and long positions in a currency like the Dollar.

Hedge fund behavior

Fung and Hsieh (2000) analyzed the impact of hedge funds in a variety of market events between the 1987 Stock market crises until the Asian crisis of 1997. They estimate the market impact of hedge funds by measuring their exposure based on their returns. They found that especially during the 1992 ERM crisis and 1997 Asian crisis, hedge funds were, like other large investors, significantly engaged in carry trades. These trades were fuelled by the fact that many countries were applying a pegged exchange rate. As long as this peg is credible, interest



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