Empirical Evidence on Exchange Rate Exposure

Chi-Yang (Ben) Tsou

March 25, 2022

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Introduction
A Review of F/S

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Introduction
So Why Do We Care? (Con’d)

Figure: Exposure and Firm Value

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Introduction
Recall

Changes in exchange rates alter the terms of trade which in turn affects

a firm’s current and future cash flows

its stock price (DCF model)

Even if a firm manages its transaction and translation exposure (e.g. hedging)

changes in the economy can provide significant variability in cash flows

Economic exposure: the sensitivity of the future home currency value to random
changes in exchange rates:

assets and liabilities

the firms operating cash flow

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A First Stab At Measuring Exposure
Before we start

Adler and Dumas (1984):

Currency risk and exposure are not the same

An anticipated movement is not risky
because of the very fact that it is expected

Risk, therefore, relates to unanticipated movements

Still face exposure to exchange rate movements
even if the movement is anticipated
the key component is the unanticipated part

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In their words. . .

“A currency is not risky because devaluation is likely. If the devaluation

were certain as to magnitude and timing, there would be no risk at all. A
weak currency can be less risky than a strong currency. A strong currency
does not become risky because it has been used to denominate an
individual’s or a firm’s debt. In short, expected exchange rate changes can
be anticipated. Risk or uncertainty is a question of randomness, i.e.,
unexpected exchange rate variations. Currency risk is not the exposure.
Currency risk is to be identified with statistical quantities which summarize
the probability that the actual domestic purchasing power of home or
foreign currency on a given future date will differ from its originally
anticipated value. Exposure, in contrast, should be defined in terms of
what one has at risk. The question at hand is how to measure it.”

– Quoted from Adler and Dumas (1984), p.42

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Measure of Risk Exposure

Adler and Dumas (1984): Exposure is a regression coefficient

A US MNC concerns about the dollar value of a foreign asset in GBP
The value of the asset were to remain unchanged in GBP
Q. Should the US MNC worries about it?
Ans: Yes! The value in USD is P = S × P ∗
S: the exchange rate
P ∗ : the value of the asset in the foreign currency (e.g., GBP)

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Measure of Risk Exposure (Con’d)

The sensitivity (exposure) of the value of the asset in the domestic

currency to exchange rate movements is:

Cov(P, S)
b=
Var(S)

Cov(P, S): covariance btw the domestic value of the asset (dollar value
in this case) and the exchange rate
Var(S): variance of movement in the exchange rate

Guess where we can get an estimate of b from?

Ordinary Least Square (OLS) regression
Software: Excel, Stata, Python, R, and etc

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Regression
Consider the following general regression equation:
yt = a + bxt + et ,

a: intercept term
et : random noise term (white noise)
It just so happens that the estimate of b from this regression is:
Cov(y , x)
b=
Var(x)
If we define y = P x = S, then b measures exposure:
the sensitivity of the domestic price of the foreign asset to exchange
rate movements
In other words, if we estimate:
Pt = a + bSt + et ,
b is our measure of exposure
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So We’re Ready To Go, Then?

NOT QUITE!

We often do not have access to P

limited information on the value and cash flows of an individual asset

What can we use instead?

Remember, we are looking to use in some shape or form: what’s

(usually) the most readily available measure of value?

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Jorion (1990)

We could use
Rit = β0i + β1i Rst + eit ,

Rit : firm i’s stock return at time t

Rst : change in a trade-weighted exchange rate, measured as the dollar
price of foreign currency
β0i : intercept of firm i
β1i : firm i’s exposure coefficient

This regression is ok if movement in Rit and Rst are unanticipated

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Jorion (1990) (Con’d)

An alternative regression to explicitly control for market movements:

Rit = β0i + β2i Rst + β3i Rmt + eit ,

Rmt : return on market portfolio at time t (e.g., S&P 500)

So what happens?

Look at how many times the exposure coefficient is significant

Look at the cross-sectional dispersion

Note: Jorion refers to β2 here rather than β1 to emphasize it is a

different regression. β2 is the exposure coefficient in this regression.

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Jorion (1990)
Table 2

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Jorion (1990)
What If We Control For Foreign Operations?

Jorion modifies the regression to allow for this:

Rit = β0i + (γ0 + γ1 Fi )Rst + β3t Rmt + ηit

Fi : ratio of foreign sales to total sales

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Jorion (1990)
Table 3

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The Dog That Didn’t Bark and Explanations That Must

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The Dog That Didn’t Bark and Explanations That Must
A Perfective from the History toward Jorion (1990)

1 Gold standard (1870-1930s):

a country’s currency directly linked to gold
2 Bretton Woods system (1944-1973):
fixed exchange rate regime
the US dollar as the dominant reserve currency
convertible to gold at the fixed rate of $35 per ounce
historical episodes:
Smithsonian Agreement in 1971
oil crisis–1973, 1979

3 Floating exchange rate system (1973-current):

THE REASON we are here!
Remark: the sample period (1971-1987) is intrigue
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Are Jorion’s findings unique?
By no means, and it’s not unique to the US. The review article by
Bartram and Bodnar (2007) provides more details, but here’s a
selection:
Bodnar and Gentry (1993) find a low proportion of industry portfolios
have significant exposure
US : 28% (11/39), Canada : 21% (4/19), Japan : 35% (7/20)
Impact of exchange rate movements on industry returns larger for
Canada & Japan than for US – consistent with exchange rate having a
larger impact on smaller and more internationally oriented economies
Choi & Prasad (1995) found significant exposure for only 15% of the
409 US MNC in their sample, this falls to 10% when industry portfolios
are used
Bartram and Karolyi (2006) look at the exposure of a large sample of
nonfinancial firms in 18 European countries, the US and Japan. Guess
what? There’s not much evidence of significant exposure
Doidge et al (2006) look at the exchange rate exposure of over 17,900
firms from countries in Europe, Asia and North America. 8.2% of firms
have significant exposure coefficient
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In the words of Bartram and Bodnar (2007)

“Overall, this evidence suggests that if anything exchange rate exposure

may be marginally larger in more open, export-oriented economies (where
the market index as a whole is typically also more sensitive to exchange
rate movements), but generally conforms with Griffin and Stulz (2001),
who perform a cross-country industry analysis and conclude that the
foreign exchange rate exposure is economically and statistically small.”

– Quoted from Bartram and Bodnar (2007), p.645

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Puzzle

Exchange rates are a major source of uncertainty for MNCs

From basic models in Finance we would expect to find significant

exchange rate exposure for MNCs at the very least and perhaps even
for firms in general

Instead, we apparently find quite the opposite

Remark
This is known as the “exchange rate exposure puzzle”

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Additional Explanations
Dominguez and Tesar (2006)

Exposure correlated with:

firm size
multinational status
foreign sales
international assets

Exposure varies through time – firms adjust behavior

different foreign exchange regimes
corporate hedging

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Dominguez and Tesar (2006)
Figure 1a

Figure: Firm-level exposure

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Dominguez and Tesar (2006)
Figure 1b

Figure: Industry-level exposure

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Explanations for Weak Findings

Selection of firms with limited exposure:

opposite exposures or low cost reactions to international conditions

Size and degree of the openness of the economies in which industries operate
Nature of the operations of firms within industries

Use of internal and external hedging techniques

Use of trade weighted exchange rates: use actual exchange rates?

Time variation in exposure/nonlinearity in exposure?

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So All is Lost?
No!

Bredin and Hyde (2011):

Analyze industry exposure

Focus on unexpected exposure to the exchange rate
anticipated exposure should be reflected in asset prices already
Realized changes in the rate as the proxy for unexpected changes
implies the exchange rate follows a random walk. Why?

St+1 = St + εt+1 ⇒ ∆St+1 ≡ St+1 − St = εt+1

Further Decomposition of the sensitivity (exposure) into news about

future cash flows
future excess returns

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Bredin and Hyde (2011)

“The level of foreign exchange exposure is dramatic once we take into

account the channel through which the influence occurs. We find
intuitively appealing results that open markets, such as Canada and
Germany are particularly sensitive to foreign exchange exposure. However,
we also find evidence of widespread foreign exchange exposure for US
industries. . . The influence of foreign exchange exposure appears to
transmit via the cash flow channel for the more competitive and open
markets.”

– Quoted from Bredin and Hyde (2011), p. 1139

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Bartram and Bodnar (2012)

The level of exposure is conditional on the exchange rate change

The Idea:
Positive and negative exchange rate changes occur with roughly the
same frequency
The average currency premium is close to zero
We shouldn’t therefore be surprised empirical tests don’t find an
unconditional relationship
The relation between stock returns and exchange rate exposure should
condition on whether the realized change in the exchange rate is
positive or negative
We may expect a positive relationship for local currency depreciations
and a negative one for local currency appreciations
The unconditional relation, however, is insignificant on average

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Bartram and Bodnar (2012) (Con’d)

“[W]e document that while there does not appear to exist an

unconditional relation between exchange rate exposure and stock returns,
such a relation does exist on a conditional basis, where the conditioning
variable is the realized change in the exchange rate itself. The economic
magnitude of this relation is significant, ranging from just over 1-3% per
unit of exposure for local currency appreciations and depreciations
respectively. The relation is more significant amongst emerging market
firms, but present to a lesser degree for firms in developed markets as well
(especially for local currency depreciations).”

– Quoted from Bartram and Bodnar (2012), p. 25–26

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Ye, Hutson and Muckley (2014)

Does the exchange rate regime matter?

examine the exposure of firms in emerging markets
around half the firms face significant exchange rate exposure:
a bit higher than firms in developed markets

Examine whether the exchange rate regime affects these findings

Magnitude of exposure: larger for firms in countries with pegged
exchange rate regimes than in floating regimes
Take-away points regarding non-floating regimes
cannot protect firms from exposure
encourage firms to take risks and/or reduce their incentive to hedge
less awareness of exchange rate risks
Example: 1997 Asian financial crisis

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What You Should Understand...

1 Exchange rate exposure puzzle...

2 Difference between cash flows and returns...
3 Reasons for why estimated exposure is low...
4 Determinants of exposure...

Q. What about hedging?

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Readings

There is a vast literature on the exposure puzzle. Some review articles

which you would be very wise to consult are
Bartram, S. and M.G. Bodnar, 2007, The exchange rate exposure
puzzle, Managerial Finance 33, 642–666.
Muller, A. and W.F.C. Verschoor, 2006, Foreign exchange risk
exposure: Survey and suggestions, Journal of Multinational Financial
Management 16, 385-410.
These articles have extensive reference sections at the end of the articles
so you can follow up on studies you think look interesting

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Other Readings

Adler, M. , Exposure to currency risk: definition and measurement and B. Dumas,

1984, Financial Management 13(2), 41–50.
Bartram, S., 2008, What lies beneath: Foreign exchange rate exposure, hedging
and cash flows, Journal of Banking and Finance 32, 1508–1521.
Bartram, S. and M.G. Bodnar, 2012, Crossing the lines: The conditional relation
between exchange rate exposure and stock returns in emerging and developed
markets, Journal of International Money and Finance 31, 766-792.
Bredin, D. and S. Hyde, 2011, Investigating sources of unanticipated exposure in
industry stock returns, Journal of Banking and Finance 35, 1128-1142.
Dominguez, K.M.E. and L.L. Tesar, 2006, Exchange
Jorion, P., 1990, The exchange rate exposure of US multinationals, Journal of
Business 63, 331–345.
Ye, M., Hutson E. and C. Muckley, 2014, Exchange rate regimes and foreign
exchange exposure: The case of emerging market firms, Emerging Markets Review
21, 156-182.

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 The End

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