The foreign exchange exposure of UK non-financial firms: A comparison of market-based methodologies

Abstract

We use a sample of 269 UK non-financial firms to study the sensitivity of foreign exchange exposure, and its determinants, to the different estimation methods. The standard Jorion's model suggests that 14.93% (30.50%) of the firms in our sample are exposed directly or indirectly to the fluctuations in the TWC (the US$, the Euro or the JP¥). However, the exposure increases substantially to 85.13% (96.65%) when time varying exposure regressions with orthogonalized market returns are used. We also show that the determinants of currency exposure are model-dependent. While the cross-sectional results suggest very little or no relationship between firm-specific factors and currency exposure, the explanatory power of these factors increase when data is pooled across firms and time. JEL Classifications: F31; F23Keywords: Foreign exchange exposure; Currency risk; Panel estimation 2 IntroductionSeveral studies predict that all firms should be subject to foreign exchange exposure as their cash flows are affected, directly or indirectly, by exchange rate movements (Shapiro, 1975;Heckman, 1985;Levi, 1994;Marston, 2001). In the light of this, it is puzzling why most empirical studies show that foreign exchange fluctuations have little or no impact on stock returns (Jorion, 1990;Bartov and Bodnar, 1994;El-Masry et al. 2007;Hutson and Stevenson, 2010).This study uses a sample of 269 UK non-financial firms to investigate whether the weak empirical association between exchange rate changes and stock returns can be attributed to bad model problems. Our analysis makes three important methodological contributions to the literature on the foreign exchange exposure of individual firms. First, we relax Jorion's (1990) assumption that foreign exchange exposure is constant over time.Several studies (Smith and Stulz, 1985;Allayannis and Weston, 2001;Dunne et al., 2004) show that a firm's exposure to exchange rate movements is related to firm-specific factors, such as size, liquidity, hedging activities and growth opportunities, which are expected to vary over time. We use GARCH-based two-factor asset pricing model with time varying coefficients (GARCH-TVC hereafter) to model the time varying nature of firms' exposure to currency movements. 1 Second, Priestley and degaard (2007) argue that the exposure coefficient obtained from Jorion's model does not capture the stock's total exposure to the foreign exchange movements. Instead, it only measures the stock's exposure over and above that of the market portfolio. Priestley and degaard (2007) suggest that orthogonalized, rather than actual, market returns should be used to estimate the exchange rate exposure. We improve on Priestley and degaard's (2007) methodology by allowing the coefficients and the residuals of the orthogonalized regressions to vary over time. Finally, previous studies use cross-sectional analysis to examine the determinants of the foreign exchange exposure.Although some of these determinants, such as industry, vary only across firms, others vary across firms a...

The Impact of Exchange Rate Movements on Firm Value in Visegrad Countries

“…Nevertheless, as Ampomah et al (2013) state, several firm-level studies reveals the weak empirical findings. Foreign exchange exposure is specified as the slope coefficient resulting from relationship between stock returns and changes in the exchange rate.…”

“…Bodnar et al (2002) discuss company's exposure as a dependent variable of its ability to pass on the increased expenses or prices caused by exchange rate changes to the consumers. As Ampomah et al (2013) states, this, depends on industry competitiveness, which determines the price elasticity of demand, and the degree of substitutability of the goods.…”

Derivative activities and Chinese banks’ exposures to exchange rate and interest rate movements

“…They show that the US industry exposure to the Japanese Yen (JP¥) increases from 10.34% to 27.58% when orthogonalised rather than actual market returns are used in the exposure regressions. Agyei-Ampomah et al (2013) show that the overall number of UK non-financial firms exposed to at least one of the three major currencies (US$, Euro or JP¥) increases from 30.50% to 52.8% following the orthogonalisation of market returns.…”

“…However, several studies show risk exposure is time-varying (see, for example, Patro et al 2002;Agyei-Ampomah et al 2013).…”

“…Finally, the time varying exposure coefficients allow us to use panel regressions to examine the determinants of banks' exposure to interest rate and foreign exchange fluctuations. In addition to their ability to overcome the small-sample size problem, panel regressions deal with the potential biases associated with 2 A similar approach was adopted by Patro et al (2002) and Agyei-Ampomah et al (2013) to study the foreign exchange exposure of non-financial firms and stock indexes, respectively. 3 Priestley and Odegaard (2007) also uses orthogonalised market returns to estimate the total exposure of nonfinancial firms to foreign exchange movements.…”