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Foreign Exchange Exposure of “Domestic” Corporations

Article  in  Journal of International Money and Finance · December 2010

DOI: 10.2139/ssrn.890584 · Source: RePEc

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Journal of International Money and Finance 29 (2010) 1619–1636

Contents lists available at ScienceDirect

Journal of International Money

and Finance
journal homepage: www.elsevier.com/locate/jimf

Foreign exchange exposure of “domestic” corporations

Raj Aggarwal a,1, Joel T. Harper b, *
a
Frank C. Sullivan Professor of International Business and Finance, University of Akron, Akron, OH 44325, USA
b
Associate Professor of Finance, Spears School of Business, Oklahoma State University, 700 N. Greenwood Ave., Tulsa, OK 74106, USA

a b s t r a c t

JEL classification: Unlike prior studies on foreign exchange risk that have focused on
F23 multinational companies, this paper documents that domestic
F31 companies face significant foreign exchange exposure. Indeed, we
G15
document that on average domestic company foreign exchange
Keywords: exposure is not significantly different from the exposures faced by
Exchange rate exposure multinational firms. As expected, the number of domestic firms
Foreign exchange risk with significant foreign exchange exposure increases with the
Currency exposure exposure estimation horizon. More interestingly, the level of
Currency risk domestic firm exposure is significantly negatively related to firm
size and asset turnover, and positively related to the market to
book ratio and financial leverage. Our results have important
implications for managers, policy makers, and accounting
standards.
Ó 2010 Published by Elsevier Ltd.

1. Introduction

How exchange rate changes affect both national economies and the returns and cash flows of
corporations has been the subject of much theoretical and empirical research in economics and
finance. The fact that most, if not all, such studies in finance have used a sample of multinational
corporations to test the nature and causes of foreign exchange exposure is not surprising. Such firms
have cash flows and asset and liability values that are directly affected by exchange rate movements.
Foreign exchange exposures for such firms affect not only the values of foreign operating cash flows,
but also the foreign asset and liability values reported in consolidated financial statements. While
earlier studies found mixed results regarding foreign exchange rate exposure, recent empirical

* Corresponding author. Tel.: þ1 918 594 8460.

E-mail addresses: aggarwa@uakron.edu (R. Aggarwal), joel.harper@oksate.edu (J.T. Harper).
1
Tel.: þ1 330 972 2780.

0261-5606/$ – see front matter Ó 2010 Published by Elsevier Ltd.

doi:10.1016/j.jimonfin.2010.05.003
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1620 R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636

evidence has demonstrated that many industries and corporations face significant exchange rate
exposure. These mixed results regarding significant foreign exchange exposures have been attributed
to multinational companies’ ability to construct effective hedges against many foreign exchange risks
using financial and operating procedures.
While not a subject of study in prior literature, perhaps surprisingly ‘domestic’ companies also
face foreign exchange risk. Consider a chemical company located in West Virginia that converts coal
into bulk chemicals. The company buys all of its inputs domestically and sells all of its output
domestically also and deals only in US dollars. All of its inputs originate in the US and all of its output
is bought and used in the US. It is usually argued that such a “domestic” company has no reason to
hedge against currency risk. However, profits of this company are strongly and negatively correlated
with the Japanese yen. As the yen rose, Japanese purchases of US coal increased and so did the US
price of coal – with a resultant drop in profits for the chemical company. As this example illustrates,
“domestic” companies can be exposed to currency risk through international competition in the
markets for its inputs and/or its outputs. An alternative example is a regional retailer who purchases
goods from a wholesaler located in the US, and not directly from manufacturers. The foreign
exchange exposure the wholesaler experiences by dealing with foreign manufacturers can be passed
through to their customers, the regional retailer. With increasing globalization of financial and
product markets, ever larger numbers of domestic companies are likely to be exposed to foreign
exchange risk as they increasingly compete indirectly with foreign firms and more directly with
international firms based in their own domestic economy. However, the foreign exchange risk
exposure of domestic companies has not been investigated in prior literature.
Due to the indirect nature of foreign exchange exposure for domestic companies, they are unlikely
to engage in hedging activities (and are thus even more likely to have foreign exchange exposure).
Indeed, accounting rules favor derivative-based hedges only against identifiable foreign exchange
exposures, favoring multinational and other companies with direct international transactions. With
the rising globalization of financial and product markets, domestic firms increasingly face foreign
exchange risks not only through interest rate and financial markets, but also through product markets
as their competitors, suppliers, and customers engage in cross-border transactions.
The purpose of this study is to measure and determine exchange rate exposure for a sample of
domestic firms that have little or no discernable international transactions but may face indirect
exposure to currency movements. A secondary goal of this study is to examine the determinants of any
such foreign exchange exposure for domestic companies. We contend that the measured exposure for
domestic corporations is likely to be significant and similar to what has been reported for multinational
corporations. In an increasingly globalizing economy, domestic corporations, their suppliers, and their
customers are not insulated from the effects of international economic cycles, currency movements,
and global competition.
The findings of this study document significant foreign exchange exposures for domestic corpo-
rations. Indeed, on average, domestic firm exposure to foreign exchange risk is not significantly
different from the exposures faced by multinational firms. We find the number of exposed domestic
firms and their level of exposure increases with the time horizon used to estimate exposure. We also
document that the level of domestic firm exposure is related negatively to firm size and asset turnover,
and positively to the market to book ratio and financial leverage. These are important findings that are
of interest to managers, accounting standard setters, and policy makers.
The next section reviews the nature and measurement of foreign exchange exposure, followed by
the description of the data and research methods used in this study. Section 4 presents the empirical
results followed by the concluding summary of the findings.

2. Nature and measurement of foreign exchange risks

Prior literature focuses on the foreign exchange exposure of multinational companies. The theo-
retical literature investigating the nature of exposure to exchange rates includes Shapiro (1975),
Aggarwal (1976), Heckman (1985), Flood and Lessard (1986), and Levi (1994). These studies identify
deviations from parity conditions, errors in forecasting future cash flows, the degree of competition,
and substitutability of factors of production as the primary factors in a multinational corporation’s
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R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636 1621

foreign exchange exposure. Marston (2001) shows the industry competitive structure may also be a key
determinant of foreign exchange exposure. However, these theoretical studies leave many empirical
issues unaddressed.2
In early studies, Aggarwal (1981) and Adler and Dumas (1984) present a method of estimating
foreign exchange exposure of a firm using a single factor market model to estimate the elasticity of firm
equity returns to exchange rate changes. Jorion (1991) estimates exposure using a two factor model
that thereafter became the norm for estimating foreign exchange exposure controlling for market risk.
For a sample of firms drawn from the Fortune 500, he finds that the degree of exposure varies directly
with the degree of foreign involvement. Other studies have re-confirmed these basic findings regarding
the foreign exchange exposure faced by multinational companies, and explored in greater detail
various issues that arise in the procedures used for estimating such exposure - issues that are
important considerations in this study.
The single factor model of measuring exposure is based on Adler and Dumas’ (1984) and measures
the total foreign exchange exposure of the firm as:

Ri;t ¼ a þ gi XRj;t þ 3i (1)

where, Ri,t is the return of firm i, over time period t, XRj,t is the exchange rate change of currency or
currency index j over time period t. The coefficient gi measures the firm’s total exposure to exchange
rates. The two factor model to measure foreign exchange exposure, based on Jorion (1991), uses
a market index in addition to the exchange rate as an independent variable3:

Ri;t ¼ a þ bi Rm;t þ gi XRj;t þ 3i (2)

where, Rm,t is the return on the market index and the rest of the variables are defined as above. In the
second equation, gi measures the firm’s residual foreign exchange exposure to the foreign exchange
exposure of the market. The two factor model has been used in a variety of studies of foreign exchange
exposure such as Bodnar and Gentry (1993), Bartov and Bodnar (1994), Bartov et al. (1996), Griffin and
Stulz (2001) among others.
However, Fama and French (1992, 1993) have found that firm returns are also sensitive to factors
other than the market index. The third approach to estimating corporate foreign exchange exposure is
then:

Ri;t ¼ a þ b1 MRPt þ b2 SMBt þ b3 HMLt þ gi XRj;t þ 3i (3)

where MRP is the market risk premium (market return minus risk free rate) and replaces the market
index return used in the previous two models, SMB is the return of small stocks minus large stocks and
HML are the returns for value relative to growth stocks.4
The question of the appropriate measure of exchange rate changes to use in the model, XRj,t, has
been generally answered by using a basket of currencies, usually trade-weighted. Several trade-
weighted dollar indexes exist, including the Major currency, Broad currency, and OITP (other important
trading partners) index. The selection of which currency index to use is not determined by theory or
the model used. The benefits of using an index rather than a single currency is that it captures the

2
The extent of price changes in response to exchange rate changes has been addressed at the macro-economic level (not at
the individual firm level) in the exchange rate pass-through literature. For example, Bodnar et al. (2002) examine the extent of
such pass through. As in other pass through studies, they find incomplete pass through that rises with the estimation horizon
with the results consistent with sticky prices and firms pricing to market. While this macro-economic literature is interesting,
this study focuses on exposures of individual firms.
3
While there is some controversy about the nature and size of the currency risk premia, a number of studies, such as
DeSantis and Gerard (1998), document that foreign exchange risk is priced even after accounting for the systematic risk
associated with the market index.
4
In contrast to the traditional market model, Dewenter et al. (2004) use an event-study methodology to measure exposure to
declines in the Mexican peso and Thai baht finding exposures not as large as anticipated due to possible operational and
financial hedges used by the sample multinational corporations. Unfortunately, with floating rates there are few such events of
interest to many companies limiting the use and usefulness of this method.
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economy-wide and aggregate change in the home currency’s value and represents the currency
environment that a firm would face on average. However, this measure of exposure tends to net out
multicurrency effects faced by a particular firm or industry. Some firms may be exposed only to one or
more currencies that may not be perfectly correlated with the index being used to estimate exposure,
giving rise to a misleading estimate of foreign exchange exposure. Instead of using an index, other
studies have measured exposure to specific currencies especially where a firm or industry may have
a particularly high exposure to a particular currency through trade or foreign operations. Williamson
(2001), Koutmos and Martin (2003), and Martin and Mauer (2003), demonstrate the appropriateness
of using individual currencies to measuring foreign exchange exposure.
Another empirical problem encountered in these studies, as well as in other areas of research in
finance, is the appropriate market index to use. While the exposure to the market index is not of
primary concern here or in other foreign exchange studies, the choice of market index has been noted
as important in estimating foreign exchange exposure. Bodnar and Wong (2003), and Pritamani et al.
(2004) demonstrate the changes in estimated foreign exchange exposure when the index changes. In
a variation of the two factor model, Pritamani et al. (2004) explores reasons for the relatively small
estimated exposures of multinationals and trade firms in the US. They hypothesize that this may be
caused by the choice of the market portfolio used in estimation. Using a total CRSP portfolio incor-
porates a degree of foreign exchange exposure. Consistent with economic theory, using an equally-
weighted domestic CRSP portfolio produces more significant foreign exchange exposure estimates for
a portfolio of exporting firms and a portfolio of importing firms.
A third issue discussed in this literature is the appropriate time horizon to estimate foreign
exchange exposure. Generally, in practice this issue has two aspects. First, is the question of whether
the exposure is contemporaneous in nature or if there is a time lag between exchange rate changes and
the resultant effect on firm value. The second is the question of estimation horizon for measuring
foreign exchange exposure. Bartov and Bodnar (1994) use a sample of firms that have significant
financial statement exposure and do not find a contemporaneous relationship between firm returns
and changes in the dollar, but find a stronger relationship with lagged dollar changes. These results
indicate a need for time to adjust business operations and undertake other hedging activity in response
to exchange rate changes. Other studies find a contemporaneous relationship between exchange rate
changes and firm value and some studies have used GARCH models allowing for time-varying exposure
to estimate foreign exchange exposure such as in Koutmos and Martin (2007).
Earlier studies used a monthly, contemporaneous horizon to measure exposure. However, if the
impacts of these exchange rate changes are longer lasting or more permanent in nature, then longer
estimation time horizons may be more appropriate. This question of estimation time horizon has been
addressed in studies such as Chow et al. (1997), Bodnar and Wong (2003) and Martin and Mauer
(2003). While generally these studies find that the estimated number of firms with significant
foreign exchange exposure is higher for longer time horizons, Bodnar and Wong are cautious in rec-
ommending very long-term horizons that may lead to limited non-overlapping time periods.
Another issue in developing foreign exchange exposure estimates has to do with portfolio size.
Generally, there are two major choices in this regard. The first method is to estimate exposure on the firm
level and the other method is to estimate the exposure for portfolio groupings, formed either by size,
industry, level of international activity, or another criteria. Many studies assess both the firm level and
portfolio level exposures. As indicated earlier, prior studies have focused on exposures of internationally
involved or multinational firms. Using a large sample of firms from many different countries, Doidge
et al. (2006) find that foreign exchange exposure is related to the level of foreign activity. They also
find that large firms exhibit more foreign exchange exposure than smaller firms after controlling for the
level of foreign activity. Bartov et al. (1996) find an increase in equity volatility following the breakdown
of the Bretton Woods agreement and increased exchange rate volatility but equity risks increased much
more for firms with a multinational presence than it did for a control sample of domestic firms. Similarly,
Jorion (1990) uses a two factor model for sample portfolios of large corporations and found the exposure
varied with the degree of foreign involvement while the exposure for a sample of domestic firms is not
significantly different from zero. Indeed, most of these prior studies on foreign exchange exposure of
companies did not examine domestic firms directly but their results imply that domestic firms should
have the lowest and most likely little or no exposure to foreign exchange risks.
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R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636 1623

As has been noted in theoretical studies, industry effects also seem important in estimating foreign
exchange rate exposure. In a study of individual bank exposures, Martin and Mauer (2003) find the vast
majority of domestic banks exhibit exposure to at least one major currency and this exposure is greater
than in a sample of internationally oriented banks with longer-term exposures more prevalent than
short-term exposures, consistent with Bodnar and Wong (2003) and Chow et al. (1997). Using a two
factor and a multifactor arbitrage pricing model, Jorion (1991) finds that exchange risks differ across
industry portfolios. Bodnar and Gentry (1993) using data from the US, Canada and Japan also find
industry differences in foreign exchange exposure and note that that the exposure direction and level are
broadly consistent with economic theory. Using a sample of firms in the automotive industry in the US
and Japan, Williamson (2001) finds that foreign sales are a major determinant of exposure but there is
considerable time variation in exchange rate exposure. However, Griffin and Stulz (2001) find the effect
of exchange rate shocks is minimal in explaining relative US industry performance and is even smaller in
other countries that are more open to trade finding that industry effects are more significant than
exchange rate effects. While there may be some differences in empirical findings, as Marston (2001)
shows, foreign exchange exposure most likely depends on the competitive structure in an industry.
Additional firm characteristics have also been assessed as to their impact on foreign exchange
exposure. He and Ng (1998) use a sample of Japanese firms and find that a quarter of their sample of
multinational firms have exposure and is positively related to size and negatively related to financial
leverage. Koutmos and Martin (2003) use industry sector portfolios from four countries and find that
exchange rate exposure is asymmetric over different appreciation-depreciation periods. Furthermore,
these asymmetries are more pronounced in the financial and non-cyclical sectors.
Overall, studies of foreign exchange exposure find that multinational corporations and corporations
with extensive foreign business have significant foreign exchange exposure. However, most studies
find that this estimated exposure is less than expected by economic theory perhaps due to operational
and financial hedges used by companies facing foreign exchange exposure. In confirmation a recent
study by Bartram et al. (in press) models and analyzes the effects of pass-through, operating hedges,
and financial hedges. They find financial hedges reduce exposure by 40% while pass-through
arrangements and operational hedges reduce exposure by 10–15%.
While a few studies have included domestic firms without foreign activity and generally found
them not to be exposed to foreign exchange risk, no prior study has addressed the determinants of
foreign exchange exposure of domestic firms. The foreign exchange exposure of a domestic firm is
indirect in its very nature. Such exposure can come via competition with firms directly exposed as well
as via pass-through exposure when dealing with a wholesaler who sources foreign goods or
a distributor selling goods in a foreign country. Thus, while a domestic firm does not deal directly with
foreign exchange rates, it faces indirect exposure to exchange rates through its suppliers, customers, or
competitors. Is such indirect foreign exchange exposure of domestic firms significant and if so what
types of firms are likely to be more exposed?

3. Research methods and data

3.1. Sample selection and data

While several definitions of domestic companies can be used, such as a firm conducting business
only with customers and suppliers only in its home country, the primary goal here is to identify
companies without direct interaction in the foreign exchange markets. The two companies described
in Section 1 would be classified as domestic companies. In addition, a company purchasing from a local
wholesaler or supplier, materials and goods originating in a foreign country could also be viewed as
a domestic company since their transactions take place in their own domestic currency and any
exposure to foreign exchange risk is indirect.
In developing our sample of domestic firms we start with the COMPUSTAT database. From the
universe of COMPUSTAT firms, we exclude ADRs, Canadian firms, and firms with incorporation outside
the US. From this narrowed dataset of only US firms, we next remove firms with foreign assets or assets
in geographic segments located outside the US, thus eliminating all multinational corporations from
our domestic company sample. We further exclude firms with any significant international exposure
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1624 R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636

Table 1
Descriptive statistics for the domestic company sample.

Median Average Standard deviation Minimum Maximum

Debt ratio 51.14% 49.34% 19.28% 4.51% 99.28%
Asset turnover 1.189 1.310 0.936 0.039 11.943
ROA 2.76% 2.04% 17.17% 140% 66.98%
Assets 99.7 1019.6 4094.1 1.8 94,489.8
Sales 116.4 889.1 3142.0 0.2 61,956.4
Market value 93.3 1069.8 5601.6 1.5 107,793.6
Market to book 1.82 2.79 5.95 37.19 148.01

This sample covers the period from January 1990 through December 2003 (168 months) for 1047 domestic, non-financial US
firms with at least 10 years of continuous data.

through sales by also removing from our sample any remaining firms that have foreign sales greater
than 5% of total sales.5,6
To be included in the sample, firms must have a continuous operating history for the past 10 years
and be listed on the NYSE, AMEX, or NASDAQ. We also exclude financial firms from the sample because
financials are heavily regulated. This narrows the sample to 1265 domestic US firms. These sample
firms have little or no identifiable direct exposure to foreign exchange markets.7
We use CRSP data on equity market returns for the time period, 1990–2003. Some of the sample
firms either entered or left the CRSP dataset during this time period but were in the CRSP database for
significant portion of the fourteen year period. If a firm has return data for a continuous decade, we
estimate the exposure and include the firm in our study. This requirement reduces our sample size to
1047 non-financial US domestic firms. Table 1 provides descriptive statistics for our sample of firms.
While generally these firms are the smaller firms in the COMPUSTAT universe, the sample does include
some larger firms as measured by total assets, sales, and market value. The median firm in the sample is
profitable, however, due to extreme values, the average firm showed a loss over the sample period.
The sample of 1047 US domestic non-financial firms is spread across 58 two-digit SIC codes. However,
over 50% of the sample firms are from 8 industry groupings, and over 70% of the sample is in 18 industry
groupings that have at least 20 firms in each industry classification. The largest industry classifications are
utilities, business services, chemicals and allied products, measuring instruments and medical goods,
electronic equipment other than computers, oil and gas extraction, eating and drinking places, and food
products. The largest firms in the domestic sample are generally in industries such as utilities, commu-
nication, transportation, and retail industries. The average size (based on assets, sales and market value) is
about 40% of the overall median for exchange traded firms during this time period, indicating that
domestic firms, as noted in the literature and demonstrated empirically in previous studies, are smaller
than more internationally focused firms. Nevertheless, other than in the category of the largest firms, there
is considerable size overlap between our domestic firms and the overall population of listed firms.
As previously discussed, several currency indices have been used in previous foreign exchange
exposure studies. The more commonly used ones are produced by the Federal Reserve, such as the
Broad index and the Major Currency index.8 However, the Dallas Fed and Atlanta Fed also produce
a currency index used less frequently in foreign exchange exposure studies. To a large extent, the issue
is not critical as the correlation between the indexes used is relatively high (correlation of 0.90) and the

5
Research insight only provides data on foreign sales for the previous 7 years. We use a threshold of an average of 5% of
foreign sales to total sales over the 7-year period.
6
We also limited the sample to non-positive foreign sales percentages for any year in the sample period (reducing the
sample by 66 firms). Empirical results were not sensitive to changes in this sample constraint.
7
Neither COMPUSTAT nor other accounting financial statements report the amount of foreign purchases (imports). While we
believe that firms may be using or reselling imported goods, some of them may not be directly importing these goods but using
a domestic wholesaler or distributor to purchase foreign products, making it difficult or impossible to assess the extent of
imports at the individual firm level.
8
The Federal Reserve revised the index it produces in 1998 and recomputed it so that there is a consistent and sustained
index. The current index replaced the classic index and the G-10 index with the Broad index and Major Currency index. See the
October 1998 Federal Reserve Bulletin for greater detail of index composition.
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R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636 1625

index used is a matter of researcher choice. In this study, to estimate foreign exchange exposure, we use
the Broad currency index as well as currencies of some individual country’s representing large trade
flows with the US. Individual currencies are used to measure exposure because some firms or indus-
tries are more affected by competitive pressures and currency changes originating in a particular
country or region. In addition to the Broad Currency Index, we estimate foreign exchange exposure
based on the Mark/Euro, the Japanese yen, and the Canadian dollar. All currencies and the index are in
indirect quotes, i.e., the number of foreign currency units per dollar.
Fig. 1 graphs the four currencies during the sample time period and demonstrates the need to use
several different measures of foreign exchange exposure. The yen and the Broad index are on the left
axis and the Canadian dollar and mark/euro exchange rate are on the right axis. From 1990 to about
1996, the Japanese Yen moved contrary to the Broad index and the two other currencies used, espe-
cially the Canadian dollar. The graph also demonstrates the relative volatility of the yen compared to
the other three currencies and the index, and shows how the index of foreign exchange rates tends to
smooth exposure over time.

3.2. Estimation models and methods

We estimate foreign exchange exposures with monthly, quarterly, and annual horizons. Because the
foreign exchange exposure in this study is primarily indirect and comes from competitive pressures, we
use these three relatively long time periods to measure exposure with a year as the longest estimation
horizon. Using the Fama-French three factor model and adding a currency change (Broad Currency index,
Mark/Euro, Japanese yen, and Canadian dollar currencies) variable, we estimate currency exposure from
January 1990 through December 2003 (168 months) for 1047 domestic, non-financial US firms with at
least 10 years of continuous data. To increase the number of observations for the longer (three and 12
month) horizons, we use overlapping time periods. The Newey-West procedures are then used to correct
for any econometric problems that may arise from the use of overlapping time periods.
Once foreign exchange exposures are computed for each firm, we estimate the effect of firm (and
industry) factors influencing the size of foreign exchange exposure. The ability to absorb and mitigate

180 1.80

160 1.60

140 1.40

120 1.20

100 1.00

80 0.80

60 0.60

Broad
40 0.40
Yen

20 CanDol 0.20
MarkEuro
0 0.00
0

3
-9

-9

-9

-9

-9

-9

-9

-9

-9

-9

-0

-0

-0

-0
n

n
Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Fig. 1. Exchange rates from January 1990 to December 2003 for the Broad index and national currencies used in the study.
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1626 R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636

such risk so that it does not impact stock returns depends upon company characteristics and the degree
of competition the firm encounters. Similar to prior studies, we use the average of the appropriate
financial variables for the previous years for each firm to measure financial and operational strength
and their ability to reduce exposure.
Financial strength is proxied by the debt ratio (total debt/total assets), and operational strength is
proxied by gross profit margin, asset tangibility (long-term assets/total assets), and asset turnover
(sales/total assets), while growth opportunities are measured using the average market to book ratio
(as measured at fiscal year end). In addition, we also compute the average market value of the firm
(measured by the log of equity market value) as a measure of size, and R&D expenses (R&D/Sales) as
a proxy for possible competitive advantages unique to the firm. Similarly, the Herfindahl index for each
2-digit SIC industry code is also computed for each year and then averaged over the sample period to
reflect the competitive environment within an industry. An industry Herfindahl index of 1 is a perfect
monopoly with competition increasing as the index approaches 0.
Firms with higher debt levels and higher financial risk and leverage can be expected to be more
susceptible to additional risk and should exhibit a positive relationship to foreign exchange exposure.
Firms with higher gross margins have more flexibility in pricing goods and services and can therefore
absorb shocks more easily than firms with lower profit margins and should therefore exhibit less
exposure to exchange rates. A similar argument follows for asset turnover. Firms with superior asset
management as measured by higher asset turnover should have a more natural protection against
changes in pricing and competitive environments and should exhibit relatively lower exposures to
foreign exchange risk. Therefore, we expect a negative relationship for gross profit margin and asset
turnover as influences on foreign exchange exposure.
The operational characteristics of the firm that should impact a domestic firm’s foreign exchange
risk are asset tangibility and R&D investment. Lower levels of current assets relative to total assets (high
asset tangibility) insulates the firm from changing input costs as current assets, especially inventory
and raw materials, are replaced in the firm’s operations. As a result, changes in foreign exchange rates
will have a minimal impact on the firm’s cost structure or balance sheet. Another characteristic
potentially reducing a firm’s exposure to exchange rate changes is R&D investment. Firms with high
R&D expenses typically invest in unique and proprietary products and services that insulate the firm
from both domestic and foreign competition. So, both high asset tangibility and R&D investment
should indicate reduced exposure to foreign exchange.
Firm size, as proxied by the log of market value, and the market to book ratio are also included as
exchange rate exposure determinants. Larger firms are less likely to be affected by foreign exchange
exposure because of their greater ability to compete and are likely to be more diversified either through
product or client diversification. Finally, growth opportunities are associated with greater exposure to
risk, so our proxy for growth opportunities, the market to book ratio, should exhibit a positive rela-
tionship to risk, including foreign exchange exposure.
Finally, our model also includes the industry Herfindahl index and industry dummy variables based
on two-digit SIC codes. Herfindahl measures should be negatively related to foreign exchange exposure
levels as it is more difficult to pass through the effects of exchange rate changes in highly competitive
industries. We also include a dummy variable for most two-digit SIC industries that have more than 20
firms represented in the sample (about half of the sample falls into the 10 most frequent industry
groups). Firms in some industries, such as petrochemical firms or other commodity based firms, will be
more affected by exchange rate movements, than firms in other industries like restaurants that may be
less influenced by cross-border activity.
The estimated model for the determinants foreign exchange exposure takes this form:

jg
b i j ¼ a þ b1 Debt þ b2 Turnover þ b3 PrMargin þ b4 Size þ b5 MkBk þ b6 IndHerf
X
n
þ b7 AssetTangibility þ b8 R&D þ bj SICj þ 3 (4)
j¼8

where Debt is the average debt ratio, Turnover is the average asset turnover, PrMargin is the average
gross profit margin, Size is the averaged log equity market value of the firm, MkBk is the average
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R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636 1627

market to book ratio, IndHerf is the average industry Herfindahl index, Asset Tangibility is the average
long-term assets to total assets ratio, R&D is the R&D expense ratio (all as described above) and SICj are
the industry dummy variables.
This model is estimated both for a sample of all firms and then only for firms with significant
exposures. The goal of these cross-sectional regressions using the full sample of domestic firms or the
firms with statistically significant estimated exposures is to determine what causes variations in the
foreign exchange exposure among firms. The estimated parameter gi indicates that some firms have
positive exposure while others exhibit negative exposure. To explain the determinants of the absolute
size of the exposures, the regression model is estimated using the absolute value of gi . But, we also
include estimates of the models separately for positive and negative exposures. In a final estimation,
we choose to use only gi estimates that are significant at the 0.10 level. These various cross-sectional
models are a very useful robustness check for the variables we find significant as determinants of
company exposure.

4. Empirical results

We estimate foreign exchange exposure using the single factor, two factor, and the three factor
Fama-French market models. As the results are qualitatively similar for all three models, as noted
earlier we present only the results using the three factor Fama-French market model.

4.1. Main results

Domestic company foreign exchange exposure estimates (not the absolute values) for each of the
exchange rate variables and time horizons are presented in Table 2. The Broad currency index, Mark/
Euro and the Yen all produce fairly similar exposure estimates and patterns. Mean exposures (except
the 12 month horizon against the Broad index and the Canadian dollar) for the full sample are generally

Table 2
Estimates of foreign exchange exposure.

Full sample Positives Negative Significant at Significant at

the 0.10 level the 0.05 level

Mean Standard N Mean Standard N Mean Standard Total þ/ Total þ/
deviation deviation deviation
Broad
One month 0.194 1.266 583 0.979 0.977 464 0.791 0.820 120 87/33 58 45/13
Three months 0.349 1.549 631 1.214 1.147 416 0.961 1.092 231 174/57 154 123/31
Twelve months 0.327 4.392 542 2.167 2.309 505 3.004 4.522 344 191/153 246 140/106

Mark/Euro
One month 0.227 0.641 635 0.581 0.542 412 0.318 0.317 157 117/40 75 55/20
Three months 0.328 0.894 650 0.777 0.790 397 0.407 0.465 262 191/71 172 126/46
Twelve months 0.344 2.185 581 1.468 1.916 466 1.057 1.618 281 176/105 189 134/65

Yen
One month 0.066 0.546 575 0.408 0.422 472 0.351 0.359 114 69/45 61 38/23
Three months 0.173 0.725 631 0.565 0.593 416 0.421 0.450 230 148/82 138 93/45
Twelve months 0.035 1.899 560 1.167 1.547 487 1.266 1.356 345 189/156 261 149/112

Canadian $
One month 0.233 1.885 595 1.037 2.012 452 0.825 0.966 108 81/27 45 31/14
Three months 0.102 2.233 573 1.192 2.169 474 1.214 1.470 199 131/68 132 92/40
Twelve months 0.469 4.177 524 2.209 2.385 523 3.153 3.852 376 191/185 280 145/135

Averaged estimates of residual exchange rate exposure for the 1047 domestic firms used in the sample the two factor residual
exchange rate model. Estimates are for each of the foreign exchange rate measures and for three different time horizons (three
and 12 month horizons are overlapping). The full sample is divided between negative and positive exposures and reported
separately. Last four columns report the number of firms that have significant exposure at the Newey-West corrected 10% and 5%
levels, respectively.
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1628 R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636

positive and significant.9 Also reported in Table 2,10 are the positive and negative exposures which
exhibit similar patterns and the number of firms exhibiting significant positive and negative exposures
at the 0.10 and 0.05 significance levels.
At the 0.10 level, for any one currency, 10–15% of sample firms exhibit significant exchange rate
exposure for a one month horizon with this percentage rising with the estimation time horizon, varying
from 20 to 25% at the three month horizon and 27 and 37% at the 12 month horizon. However, the
number of firms exposed to at least one of the three bilateral currency measures averages 28.9%, 47.5%,
and 72.9% at the 1, 3, and 12 month horizons.11 While the increase in the number of firms with time
horizon is consistent with Bodnar and Wong (2003) and other studies that have used such longer time
horizons to measure exposure, the numbers of firms exposed are a remarkable finding given that our
sample consists of domestic firms while the samples in prior studies consisted of multinational firms.12
In studies of multinationals, positive exposures are consistent with net importers; as the value of the
dollar rises, the cost in domestic currency of imported goods decreases and cash flow (and value increases).
At the same time, as the value of foreign currencies fall against the US dollar, US businesses must compete
with “cheaper” imports and face increased competition indicating a positive relationship between the
value of the foreign currencies vis-a-vis the US dollar and the value of the domestic companies. The fact
that the estimated exposures are mostly positive indicates that the sample of domestic corporations do
face significant direct competition from the mark/euro countries and from Japan and these positive net
exposures indicate a pass-through of exchange rate changes to prices by foreign competitors/suppliers.
Over the longer horizons (12 months), net exposures reverse somewhat as domestic companies tend to
import, either directly or indirectly, goods and raw materials from these countries for processing and resale
in the US especially as measured against the Canadian dollar or the Broad index.
The next four tables present the factors determining foreign exchange exposure. Tables 3–5 present
estimates of Eq. (4) for the three different time horizons. While consistencies between the results for
each of the time horizons exist, there are marked differences illustrating how firms are affected by
exchange rate risk. Table 3 presents the results for the one month horizon for the determinants of the
absolute value of the foreign exchange exposure for each of the four currency measures for all firms and
for firms with positive and negative exposures separately. For the all firm estimates in each table, we
use the absolute value of the exposure as the dependent variable, so the coefficients of the independent
variables indicate what causes the most risk without indicating the direction of exposure.
For the one month and three month horizons, two factors seem fairly consistent. Size has
a consistent, negative impact on foreign exchange exposure, indicating that larger firms have smaller
exposures, and it is the smaller firms experiencing the largest exposures. Interestingly, this is contrary
to the findings of Doidge et al. (2006) for multinational companies. The other consistent finding is the
use of financial leverage generally increases the level of foreign exchange exposure. Firms with high
levels of leverage are less flexible in responding to changes arising from exchange rate changes. In
addition, the level of R&D expenditures and the market to book ratio also seems to have significant
positive influences on foreign exchange exposure in many cases. While these results are somewhat less
consistently significant at the 12 month horizon, in general these findings indicate that among
domestic firms, small and highly leveraged firms, and perhaps firms with high R&D expenses and
market to book ratios, face the greatest foreign exchange exposures.

9
Significance of exposures is estimated using this sample of domestic corporations as a portfolio and estimating the portfolio
sensitivity to exchange rate movements. Table 1 reports the average and standard deviation of the individual corporations
estimated exposure.
10
We also estimated foreign exchange exposures using an equally weighted index and using the lag of the foreign exchange
measure. These estimates were consistent with the results estimated using the contemporaneous exchange rate changes and
the value weighted index reported in this table with the exception of the Canadian dollar exposure for longer time horizons.
11
Interestingly, the firms exposed to each currency seem different with only 4, 32, and 17 firms were exposed to all three
exchange rates simultaneously for the 1, 3, and 12 month horizons, respectively. Further, there seemed little industry variation
in the percentage of firms exposed.
12
The percentage of firms exposed to foreign exchange rates is larger than found by Jorion (1990) for multinational firms, but
is in line with recent empirical studies of multinational firms such as He and Ng (1998), Doidge et al. (2006), and Bodnar and
Wong (2003).
Table 3
Determinants of foreign exchange exposure for one month horizons.

Intercept Debt Asset Profit Size Industry Market Asset R&D N Adj. F-stat
turnover margin Herf to book tangibility R-square
All firms
Broad 1.474 0.521 0.087 0.004 0.126 0.093 0.007 0.315 0.339 977 0.113 6.19***
(0.166)*** (0.172) *** (0.041)*** (0.005) (0.016)*** (0.631) (0.005) (0.169)* (0.450)
Euro 0.671 0.314 0.020 0.003 0.068 0.038 0.005 0.097 0.713 977 0.150 8.22***
(0.088)*** (0.021) (0.003) (0.008)*** (0.324) (0.005)* (0.087) (0.231)***
(0.085)***
Yen 0.584 0.189 0.026 0.003 0.051 0.107 0.007 0.125 0.685 977 0.154 8.39***
(0.071)*** (0.074)** (0.017) (0.002) (0.007)*** (0.270) (0.002)*** (0.072)* (0.193)***
Canadian $ 1.531 0.003 0.073 0.002 0.171 0.357 0.021 0.405 0.368 977 0.049 3.11***
(0.317)*** (0.328) (0.077) (0.009) (0.031)*** (1.204) (0.009)** (0.322) (0.859)

Positive exposures
Broad 1.581 0.654 0.044 0.015 0.132 0.455 0.005 0.559 1.713 541 0.144 4.78***
(0.234)*** (0.242)** (0.055) (0.014) (0.022)*** (0.940) (0.006) (0.236)*** (0.748)***
Euro 0.748 0.370 0.007 0.005 0.085 0.006 0.004 0.075 0.941 591 0.164 5.81***
(0.121)*** (0.122)*** (0.029) (0.005) (0.012)*** (0.489) (0.003)** (0.119) (0.306)***
Yen 0.520 0.240 0.032 0.004 0.044 0.160 0.004 0.242 0.710 538 0.125 4.20***
(0.101)*** (0.104)** (0.024) (0.002) (0.010)*** (0.388) (0.004) (0.106)** (0.266)***
Canadian $ 1.906 0.636 0.058 0.009 0.202 0.369 0.034 0.665 1.776 555 0.032 1.75**
(0.533)*** (0.562) (0.133) (0.021) (0.051)*** (1.965) (0.013)*** (0.543) (1.529)

Negative exposures
Broad 1.410 0.521 0.189 0.001 0.146 0.066 0.0008 0.016 0.426 436 0.153 4.26***
(0.224)*** (0.231)** (0.059)*** (0.005) (0.023)*** (0.785) (0.015) (0.229) (0533)
Euro 0.476 0.301 0.057 0.0009 0.039 0.234 0.009 0.142 0.619 386 0.085 2.50***
(0.103)*** (0.104)*** (0.024)** (0.002) (0.010)*** (0.339) (0.008) (0.106) (0.332)*
Author's personal copy

Yen 0.573 0.113 0.031 0.001 0.058 0.165 0.009 0.013 0.393 439 0.193 5.36***
(0.101)*** (0.105) (0.025)* (0.006) (0.009)*** (0.369) (0.002)*** (0.098) (0.302)
Canadian $ 1.209 0.514 0.105 0.003 0.133 0.197 0.008 0.059 2.336 422 0.147 4.03***
(0.262)*** (0.268)* (0.061)* (0.006) (0.027)*** (0.999) (0.013) (0.265) (0.668)***

Estimates in the determination in exposure for the absolute value of exchange rate exposure estimated with Fama-French factors in the model. Debt is the average debt ratio, Turnover is the
average asset turnover, PrMargin is the average gross profit margin, Size is the log of the average market value of the firm, IndHerf is the industry Herfindahl index, MkBk is the average
R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636

market to book ratio for the firm, Asset Tangibility is the percentage of long-term assets to total firm assets and R&D to Assets is the average R&D expense to total assets. Averages are
computed over the estimation period of foreign exchange exposure. Newey-West corrected standard errors in parentheses. Estimates of the SIC industry coefficients are not reported in the
table.
P
jg
b i j ¼ a þ b1 Debt þ b2 Turnover þ b3 PM arg in þ b4 Size þ b5 IndHerf þ b6 MkBk þ b7 AssetTangibility þ b8 R&D þ nj¼ 8 bj SICj þ 3.
***, **, and * indicate significance at the 0.01, 0.05 and 0.10 level respectively.
1629
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Table 4
Determinants of foreign exchange exposure for three month horizons.

Intercept Debt Asset Profit Size Industry Market Asset R&D N Adj. F-stat
turnover margin Herf to book tangibility R-square
All firms
Broad 1.852 0.503 0.102 0.007 0.119 0.404 0.021 0.596 0.481 977 0.102 5.63***
(0.203)*** (0.210)** (0.050)** (0.006) (0.020)*** (0.771) (0.006)*** (0.206)*** (0.550)
Euro 1.085 0.320 0.076 0.003 0.078 0.337 0.013 0.336 1.280 977 0.154 8.42***
(0.123)*** (0.127)** (0.030)** (0.004) (0.012)*** (0.466) (0.004)*** (0.125)*** (0.332)***
Yen 0.838 0.264 0.076 0.004 0.055 0.183 0.004 0.276 1.429 977 0.167 9.17***
(0.098)*** (0.101)*** (0.024)*** (0.003) (0.010)*** (0.371) (0.003) (0.099)*** (0.265)***
Canadian $ 2.079 0.010 0.130 0.006 0.178 1.117 0.015 0.108 1.733 977 0.054 3.34***
(0.361)*** (0.373) (0.088) (0.011) (0.035)*** (1.369) (0.011) (0.367) (0.976)*

Positive exposures
Broad 1.850 0.707 0.011 0.010 0.126 0.810 0.017 0.656 0.682 593 0.117 4.26***
(0.253)*** (0.272)*** (0.060) (0.006) (0.025)*** (0.976) (0.006)*** (0.256)** (0.753)
Euro 1.234 0.461 0.041 0.004 0.096 0.933 0.011*** 0.407 1.594 602 0.161 5.82***
(0.170)*** (0.175)*** (0.040) (0.004) (0.017)*** (0.736) (0.004) (0.173)** (0.452)***
Yen 0.918 0.284 0.083 0.005 0.058 0.061 0.004 0.357 1.397 590 0.170 6.04***
(0.133)*** (0.139)** (0.032)** (0.003) (0.014)*** (0.543) (0.003) (0.132)*** (0.345)***
Canadian $ 2.220 1.014 0.008 0.015 0.239 0.843 0.115 0.746 3.215 533 0.050 2.16***
(0.574)*** (0.608)* (0.139) (0.024) (0.056)*** (2.020) (0.031)*** (0.563) (2.161)

Negative
exposures
Broad 1.903 0.517 0.349 0.049 0.134 0.041 0.054 0.567 0.159 384 0.176 4.40***
Author's personal copy

(0.329)*** (0.321) (0.087)*** (0.024)** (0.032)*** (1.182) (0.019)*** (0.341)* (0.777)

Euro 0.863 0.107 0.138 0.001 0.067 0.522 0.022 0.179 0.150 375 0.113 2.99***
(0.151)*** (0.154) (0.038)*** (0.007) (0.014)*** (0.475) (0.009)** (0.150) (0.466)
Yen 0.609 0.270 0.054 0.059 0.055 0.378 0.014 0.037 1.309 387 0.184 4.63***
(0.140)*** (0.138)* (0.034)* (0.017)*** (0.013)*** (0.456) (0.010) (0.145) (0.478)***
Canadian $ 2.063 1.134 0.295 0.003 0.160 0.998 0.002 0.708 3.039 444 0.155 4.40***
(0.396)*** (0.402)*** (0.098)*** (0.009) (0.041)*** (1.609) (0.008) (0.431) (0.896)***
R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636

Estimates in the determination in exposure for the absolute value of exchange rate exposure estimated with Fama-French factors in the model. Variable definitions are the same as in Table
3. Newey-West corrected standard errors in parentheses.
P
jg
b i j ¼ a þ b1 Debt þ b2 Turnover þ b3 PM arg in þ b4 Size þ b5 IndHerf þ b6 MkBk þ b7 AssetTangibility þ b8 R&D þ nj¼ 8 bj SICj þ 3.
***, **, and * indicate significance at the 0.01, 0.05 and 0.10 level, respectively.
Table 5
Determinants of foreign exchange exposure for 12 month horizons.

Intercept Debt Asset Profit Size Industry Market Asset R&D N Adj. F-stat
turnover margin Herf to book tangibility R-square
All firms
Broad 3.767 0.565 0.037 0.021 0.207 4.267 0.006 0.483 7.753 977 0.088 4.92***
(0.651)*** (0.673) (0.159) (0.019) (0.019)*** (2.472)* (0.019) (0.662) (1.763)***
Euro 2.109 0.470 0.227 0.006 0.081 1.703 0.012 0.715 4.082 977 0.111 6.07***
(0.336)*** (0.347) (0.082)*** (0.010) (0.033)** (1.274) (0.010) (0.341)** (0.909)***
Yen 1.922 0.384 0.151 0.004 0.053 1.520 0.026 0.685 1.799 977 0.095 5.27***
(0.275)*** (0.285) (0.067)*** (0.008) (0.027)* (1.046) (0.008)*** (0.280)** (0.746)**
Canadian $ 3.644 1.653 0.031 0.044 0.217 3.963 0.022 1.248 11.806 977 0.162 8.87***
(0.586)*** (0.606)*** (0.143) (0.017)** (0.058)*** (2.227)* (0.017) (0.596)** (1.588)***

Positive exposures
Broad 2.766 0.768 0.320 0.006 0.154 2.249 0.009 0.718 0.845 513 0.071 2.63***
(0.553)*** (0.601) (0.137)** (0.016) (0.055)*** (1.863) (0.015) (0.568) (2.522)
Euro 2.043 0.543 0.184 0.006 0.039 2.127 0.005 0.960 4.300 547 0.117 4.00***
(0.487)*** (0.494) (0.131) (0.012) (0.047) (1.855) (0.011) (0.500)* (1.244)***
Yen 1.968 0.170 0.181 0.006 0.045 1.202 0.021 0.543 1.162 531 0.084 3.02***
(0.399)*** (0.403) (0.099)* (0.020) (0.039) (1.530) (0.009)*** (0.402) (1.148)
Canadian $ 2.587 0.583 0.507 0.007 0.278 1.976 0.107 0.044 4.609 494 0.096 3.18***
(0.637)*** (0.654) (0.152)*** (0.018) (0.060)*** (2.116) (0.044)** (0.630) (3.325)

Negative exposures
Broad 4.790 0.296 0.335 0.003 0.320 8.821 0.039 0.301 8.420 464 0.104 3.24***
Author's personal copy

(1.296)*** (1.239) (0.311) (0.044) (0.126)** (5.669) (0.045) (1.270) (2.737)***

Euro 2.053 0.301 0.245 0.017 0.162 1.286 0.066 0.197 2.484 430 0.077 2.49***
(0.464)*** (0.486) (0.101)** (0.022) (0.047)*** (1.722) (0.028)** (0.463) (1.534)
Yen 1.861 0.708 0.135 0.005 0.069 1.957 0.064 0.920 1.971 446 0.107 3.23***
(0.391)*** (0.407)* (0.095) (0.009) (0.039)* (1.423) (0.024)*** (0.396)** (1.023)*
Canadian $ 5.191 2.506 0.596 0.049 0.205 7.859 0.016 2.346 11.414 483 0.202 6.07***
(1.023)*** (1.039)** (0.249)** (0.032) (0.104)** (4.327)* (0.021) (1.047)** (2.302)***
R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636

Estimates in the determination in exposure for the absolute value of exchange rate exposure estimated with Fama-French factors in the model. Variable definitions are the same as in Table
3. Newey-West corrected standard errors in parentheses.
P
jg
b i j ¼ a þ b1 Debt þ b2 Turnover þ b3 PM arg in þ b4 Size þ b5 IndHerf þ b6 MkBk þ b7 AssetTangibility þ b8 R&D þ nj¼ 8 bj SICj þ 3.
***, **, and * indicate significance at the 0.01, 0.05 and 0.10 level, respectively.
1631
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1632 R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636

Other exposure determinants shown in these tables are also significant in many cases. In the many
cases when it is significant, asset turnover has a negative effect on exposure. In the cases when it is
significant, asset tangibility also has a negative effect on exposure indicating firms with less (more)
current assets have less (more) exposure indicating the exposure reflects pass-through exposure and is
related to current assets such as inventory. Industry Herfindahl index and profit margin are largely
insignificant, indicating exposure is not related to industry competitive structure.13
Other exposure determinants not shown in these tables that are consistent with regard to different
horizons are the effect of industry. Dummy variables were included in the regressions for any two-digit
SIC industry that had 20 or more firms in the sample. Not surprisingly, being in the regulated utility
industry had a significant negative impact on foreign exchange exposure as they have not faced much
foreign competition. In addition, the negative impact may also reflect the fact that some of the largest
firms in the sample are utilities. Other industries that have a consistent positive effect on exposure are
chemical products, apparel retailers, and especially business services (perhaps because of the high
degree of international competition in these industries).14
Table 6 presents estimates only for firms with significant (at the 0.10 level) foreign exchange
exposures that confirm many of the previous results from the full sample. First, size and R&D expense
ratio mostly retain their signs and significance. However, due to the smaller sample size, now the
previously weaker determinants of exposure, debt, asset turnover, market to book ratio, asset tangi-
bility, and industry concentration, mostly lose their significance.

4.2. Robustness checks

As a robustness check, we also estimated the models of foreign exchange exposure and its cross-
sectional variation using the single factor and two factor asset pricing models, using equally and value
weighted market indexes, with the results qualitatively the same as those presented above with
respect to the number of firms with positive/negative exposures as well as the significant determinants
of exposures.15 While we do not focus on tests of asset pricing models here, these supplementary
results indicate that our estimates of firm exposure presented here are not model sensitive.
In a further robustness check, we selected an additional sample of internationally oriented firms to
compare their exposure to our estimates of domestic company exposures. If a firm has 25% or more of
its sales in foreign markets (after excluding ADRs, financial firms and firms not incorporated in the US),
in each year, starting in 1997, we include it in our sample of internationally focused firms, yielding
a sample of 267 firms. While the average size of firms in our internationally oriented sample is larger
than the average size of our domestic firm sample, there is considerable size overlap in the two samples
and our international sample does include smaller firms. As we did with our sample of domestic firms,
we again estimate the exchange rate exposure using the residual exposure with the Fama-French three
factor model for the currency index and the three individual currencies for each of the three time
horizons. We then regress these estimated exchange rate exposures with firm variables in a cross-
sectional model similar to Eq. (4). An additional dummy variable was added in these estimates to
indicate if the firm was internationally focused (value of 1) or a domestic company (value of 0). The
results for the cross-sectional model including the internationally focused firms are reported in Table 7.

13
In examining exposures to different currencies, size is still almost always significantly positively related to exposure for all
four currency measures. In addition to size, exposures to the yen seem to depend positively on R&D levels and negatively on
tangible assets. Similarly, in addition to size, exposures to the Mark/Euro seem to depend positively on R&D levels and
negatively on asset turnover. Once again, in addition to size, exposures to the Canadian dollar seem to depend positively on R&D
levels and negatively on company debt.
14
In addition, we also estimated an alternative specification to industry dummy variables based on industry trade. For
a subset of firms for which 2 digit SIC industry trade data were available (mostly manufacturing firms), we computed total
industry trade (exports þ imports) to industry sales and net industry trade (exports  imports) to industry sales. We next
included each of these new industry trade variables along with the prior independent variables and re-estimated the model
without industry dummy variables. In both cases the estimated coefficients for the remaining model variables were consistent
with the reported results. We report the industry dummy variable model specification here since it also includes service firms
as well as manufacturing firms, but alternative specifications can be obtained from the authors upon request.
15
These results are not presented here for brevity sake, but are available from the authors.
Table 6
Determinants of foreign exchange exposure of firms with significant exposure.

Intercept Debt Asset Profit Size Industry Market Asset R&D N Adj. F-stat
turnover margin Herf to book tangibility R-square
One month horizon
Broad 3.132 0.462 0.119 0.398 0.241 0.003 0.043 0.498 4.676 116 0.322 5.97***
(0.465)*** (0.521) (0.110) (0.166)** (0.055)*** (1.455) (0.030) (0.475) (2.534)*
Euro 1.828 0.287 0.043 0.051 0.160 0.303 0.015 0.351 2.067 147 0.460 12.30***
(0.190)*** (0.235) (0.064) (0.045) (0.023)*** (0.542) (0.007)** (0.219) (0.729)***
Yen 1.774 0.055 0.109 0.042 0.106 0.022 0.001 0.472 1.350 110 0.413 7.98***
(0.194)*** (0.237) (0.055)** (0.043) (0.024)*** (0.719) (0.003) (0.213)** (0.592)**
Canadian $ 4.865 0.149 0.596 0.696 0.685 0.660 0.588 0.558 14.537 101 0.403 7.14***
(1.671)*** (1.975) (0.561) (0.276)** (0.196)*** (4.912) (0.164)*** (1.813) (6.418)**

Three month horizon

Broad 3.260 0.868 0.054 0.034 0.225 1.852 0.004 0.692 2.113 221 0.271 8.45***
(0.367)*** (0.407)** (0.107) (0.036) (0.040)*** (1.299) (0.007)** (0.387)* (1.259)*
Euro 2.003 0.152 0.070 0.007 0.136 1.882 0.005 0.363 2.582 249 0.348 13.0***
(0.237)*** (0.278) (0.081) (0.009) (0.027)*** (0.699)*** (0.004) (0.263) (0.792)***
Yen 1.508 0.138 0.105 0.009 0.094 0.333 0.010 0.293 2.118 222 0.450 17.4***
(0.150)*** (0.177) (0.050)** (0.007) (0.018)*** (0.526) (0.006)* (0.173)* (0.411)***
Canadian $ 3.406 1.028 0.019 0.225 0.248 2.988 0.004 0.729 3.955 182 0.315 8.56***
(0.438)*** (0.455)** (0.112) (0.224) (0.046)*** (1.461)** (0.039) (0.427)* (1.499)***

Twelve month horizon

Broad 6.230 1.401 0.157 0.045 0.418 4.146 0.097 1.489 8.741 322 0.157 6.43***
Author's personal copy

(1.134)*** (1.416) (0.266) (0.045) (0.138)*** (4.448) (0.059)*** (1.269) (3.873)**

Euro 4.620 0.225 0.423 0.021 0.143 3.673 0.003 1.330 4.966 265 0.115 4.12***
(0.721)*** (0.941) (0.241)* (0.018) (0.093) (2.491) (0.017) (0.862) (2.475)**
Yen 2.927 0.529 0.149 0.013 0.100 1.312 0.014 0.926 3.546 323 0.144 5.94***
(0.411)*** (0.491) (0.117) (0.011) (0.046)** (0.976) (0.010) (0.425)** (1.437)**
Canadian $ 5.627 2.901 0.057 0.018 0.317 4.250 0.003 2.118 11.964 354 0.298 14.6***
(0.716)*** (0.907)*** (0.175) (0.034) (0.085)*** (2.660) (0.018) (0.801)*** (2.253)***
R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636

Estimates in the determination in exposure for the absolute value of exchange rate exposure estimated with Fama-French factors in the model. Variable definitions are the same as in Table
3. Newey-West corrected standard errors in parentheses.
P
jg
b i j ¼ a þ b1 Debt þ b2 Turnover þ b3 PM arg in þ b4 Size þ b5 IndHerf þ b6 MkBk þ b7 AssetTangibility þ b8 R&D þ nj¼ 8 bj SICj þ 3.
***, **, and * indicate significance at the 0.01, 0.05 and 0.10 level, respectively.
1633
 1634

Table 7
Determinants of foreign exchange exposure (Broad index), including firms with international focus.

Intercept Debt Asset Profit Size Industry Market to Asset R&D Intl’ focus N Adj. F-stat
turnover margin Herf book tangibility R-square
One month
All 1.358 0.468 0.084 0.003 0.094 0.072 0.009 0.357 0.198 0.015 1248 0.105 6.87***
(0.140)*** (0.149)*** (0.036)** (0.005) (0.013)*** (0.570) (0.004)** (0.148)** (0.372) (0.077)
Positive 1.387 0.616 0.021 0.012 0.112 0.547 0.007 0.476 1.562 0.002 671 0.145 5.56***
(0.200)*** (0.213)*** (0.048) (0.013) (0.019)*** (0.851) (0.005) (0.209)** (0.606)** (0.112)
Negative 1.363 0.402 0.201 0.001 0.092 0.307 0.013 0.223 0.707 0.067 577 0.103 3.65***
(0.188)*** (0.202)** (0.052)*** (0.004) (0.018)*** (0.721) (0.009) (0.202) (0.456) (0.104)
Significant 3.184 0.412 0.134 0.244 0.186 0.681 0.030 0.669 3.653 0.608 149 0.292 6.08***
(0.396)*** (0.465) (0.099) (0.129)* (0.045)*** (1.303) (0.026) (0.424) (1.829)** (0.257)**

Three months
All 1.703 0.467 0.099 0.006 0.088 0.298 0.021 0.617 0.257 0.87 1248 0.096 6.45***
(0.173)*** (0.184)** (0.044)** (0.006) (0.016)*** (0.703) (0.005)*** (0.182)*** (0.459) (0.095)
Positive 1.712 0.666 0.005 0.009 0.105 0.704 0.019 0.634 0.374 0.042 715 0.124 5.04***
(0.223)*** (0.245)** (0.054) (0.006) (0.021)*** (0.900) (0.006)*** (0.232)*** (0.629) (0.132)
Negative 1.796 0.393 0.334 0.051 0.084 0.207 0.031 0.670 0.125 0.009 533 0.131 4.20***
(0.266)*** (0.275) (0.075)*** (0.023)** (0.025)*** (1.078) (0.012)** (0.291)** (0.659) (0.139)
Significant 3.033 0.587 0.090 0.029 0.181 1.774 0.007 0.551 1.620 0.329 275 0.267 9.31***
(0.329)*** (0.365) (0.098) (0.034) (0.033)*** (1.110) (0.007) (0.345) (1.053) (0.204)

Twelve months
All 3.190 0.522 0.015 0.015 0.125 3.959 0.017 0.418 6.910 0.377 1248 0.065 4.47***
(0.573)*** (0.612) (0.147) (0.019) (0.054)** (2.334)* (0.017) (0.604) (1.526)*** (0.315)
Author's personal copy

Positive 2.694 0.781 0.258 0.007 0.110 1.818 0.010 0.991 0.078 0.279 625 0.069 2.84***
(0.506)*** (0.560) (0.130)** (0.015) (0.049)** (1.784) (0.013) (0.537)* (2.052) (0.300)
Negative 3.541 0.239 0.155 0.012 0.183 8.421 0.061 0.732 6.811 0.161 623 0.071 2.90***
(1.071)*** (1.080) (0.274) (0.042) (0.099)* (5.221) (0.039) (1.100) (2.366)*** (0.558)
Significant 5.824 0.772 0.047 0.050 0.313 4.917 0.092 1.138 9.390 0.084 405 0.118 5.49***
(1.076)*** (1.339) (0.252) (0.044) (0.123)** (4.174) (0.056) (1.197) (3.398)*** (0.749)
R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636

Estimates in the determination in exposure for the absolute value of exchange rate exposure estimated with Fama-French factors in the model at different time horizons. Variable definitions
are the same as in Table 3. Int’l Focus is a dummy variable indicating the firm has a high degree of international involvement as measured by sales. Newey-West corrected standard errors in
parentheses.
P
jg
b i j ¼ a þ b1 Debt þ b2 Turnover þ b3 PM arg in þ b4 Size þ b5 IndHerf þ b6 MkBk þ b7 AssetTangibility þ b8 R&D þ nj¼ 8 bj SICj þ 3.
***, **, and * indicate significance at the 0.01, 0.05 and 0.10 level, respectively.
 Author's personal copy

R. Aggarwal, J.T. Harper / Journal of International Money and Finance 29 (2010) 1619–1636 1635

For the sake of brevity, Table 7 reports the results only for the case of significant exposures using the
Broad currency index for the 1 month, 3 months, and the 12 months horizons.16 As in the estimates
with only domestic companies, the two most consistent factors that are determinants of foreign
exchange exposure, are again firm size and, to a lesser extent, R&D expenses. The signs of the other
determinants are similar to those in prior tables but they are significant less consistently. In one of the
models the international involvement dummy variable indicates that international involvement makes
a significantly negative impact on foreign exchange exposure but this variable is not significant in other
cases. Interestingly, these results indicates that domestic companies generally have the same (or
perhaps a higher) degree of foreign exchange exposure as internationally focused firms. Overall, there
is remarkable consistency between the results regarding the determinants of foreign exchange
exposure presented in Table 7 with similar results presented in earlier tables for domestic firms.

5. Summary and conclusions

The objective of this study has been to determine if US domestic firms with little or no direct foreign
involvement are exposed to exchange rate risk. We contend that these domestic firms are likely to be
exposed to exchange rate risks because such firms face competition from foreign businesses operating
in the US, because of the use of foreign suppliers by them or their competitors, and because of interest
rate and other macro-economic effects related to changes in exchange rates.
The findings presented here document that domestic companies face significant foreign exchange
exposures. Indeed, we find that on average domestic firm exposure to foreign exchange risk is not
significantly different from the exposures faced by firms that are directly involved in international
activity. Furthermore, we show that the number of domestic firms with significant foreign exchange
exposure increases with the time horizon used to measure exposure. Further, we document that the
level of domestic firm exposure is related inversely to size, positively to the level of R&D expenses, and
to a lesser extent, positively to financial leverage and the market to book ratio, negatively to asset
turnover, asset tangibility, and industry concentration. In other words, small domestic firms that have
high market to book and debt ratios and low asset turnover located in highly competitive industries are
likely to face the highest exposure to foreign exchange risks. These results are robust to alternative
asset pricing models and other procedures to estimate foreign exchange exposure.
The results documented in this paper have many managerial and policy implications. Since it has
not been generally obvious that domestic corporations are exposed to foreign exchange risk, and
because accounting rules discourage foreign currency hedging through derivatives contracts, hedging
such exposure through financial contracts and/or operational changes is generally not done in practice
by domestic firms. Domestic company managers clearly need to re-think this issue and accounting
policy regarding the use of hedging contracts should perhaps also be re-examined.

Acknowledgements

The authors are grateful to participants at the annual meetings of the Financial Management
Association, J. Madura, A. Martin, R. Rao, N. Richie, X. Zhao, and other colleagues for useful comments,
but remain solely responsible for the contents.

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16
The other results are qualitatively similar to the results for the domestic firms reported in this paper. They are not presented
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