Analysts can measure economic exposure by using a simple regression equation, shown in Equation 1.
P = α + β.S + ε (1)
Suppose, the United States is the home country and Europe is the foreign country. In the equation, the price, P, is the price of the foreign asset in dollars while S is spot exchange rate, expressed as Dollars per Euro.
The Regression equation estimates the connection between price and the exchange rate. The random error term (ε) equals zero when there is a constant variance while (α) and (β) are the estimated parameters. Now, we can say that this equation will give a straight line between P and S with an intercept of (α) and a slope of (β). The parameter (β) is expressed as the Forex Beta or Exposure Coefficient. β indicates the level of exposure.
We calculate (β) by using Equation 2. Covariance estimates the fluctuation of the asset’s price to the exchange rate, while the variance measures the variation of the exchange rate. We see that two factors influence (β): one is the fluctuations in the exchange rate and the second is the sensitivity of the asset’s price to changes in the exchange rate.
β = Covariance (P,S)Variance (S) (2)
