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We examine the relationship between financial crisis exchange rate variability and equity return volatility for US multinationals. Empirical analysis of the major financial crises of the last decades reveals that stock return variability increases significantly in the aftermath of a crisis, even relative to the increase in stock return volatility for other firms belonging to the same industry and market capitalization class. In conjunction with this increase in total volatility, there is also an increase in stock market risk (β) for multinational firms. Moreover, trade and service oriented industries appear to be particularly sensitive to these changing exchange rate conditions.

The simultaneous growth of exchange rate uncertainty and international trade has forced managers as well as investors to pay increasing attention to the impacts of currency movements in firm value. They acknowledge moreover the fact that nowadays exchange rate uncertainty has grown to one of the most important sources of risk companies are facing. Standard economic analysis implies that movements in the exchange rate influence both the current and future expected cash flows of a firm’s operation and the discount rate employed to value these cash flows. But in reality, firms’ cash-flows are not only affected through relative price changes in input and output products and services but also through the relative values of domestic and foreign assets and liabilities. Exchange rate variability influences moreover the competitive positions of firms both in their domestic and foreign input and output markets. For the past decade, many researchers have been empirically investigating the foreign exchange risk exposure of multinational firms. Despite multinationals’ extensive involvement in international activities and the implication of economic theory, existing literature has met with limited success in identifying significant contemporaneous correlations between exchange rate fluctuations and US stock returns (see, Jorion, 1990 and Griffin and Stulz, 2001 for instance). The controversy has stimulated the interest of many researchers in similar issues involving other countries, especially those with market characteristics different from the US stock market while motivated others to explain the difficulty in obtaining stable and significant measures of exchange exposure.1 Since the debate regarding the counter-intuitiveness of previously reported results on exchange risk exposure remains, this paper presents an alternative approach to empirically assess the impact of exchange rate changes on firm value. Rather than analyzing the impact of exchange rate movements on firm value by regressing multinationals’ stock returns on exchange rate changes, we aim to increase our understanding of the (time-varying) relationship between exchange rates and stock prices by reconsidering the foreign exchange risk exposure puzzle from a different angle. Motivated by Bartov et al. (1996), we concentrate hence in this paper on the impact of increased exchange rate variability on the stock return volatility of US multinationals by focusing on the turmoil periods around the major financial crises of the last decade: Mexico’s float of the peso in December 1994, Argentina’s financial crisis and its efforts not to devalue the Argentine peso in March 1995,2 Brazil’s decision to let the real float in January 1999, and the Asian financial crises in Thailand, Malaysia, Indonesia and Korea in July, August and December 1997.3 More specifically, we analyze the change in US stock market risk (β) in response to the onset – or fear – of a exchange rate regime shift in countries where these US multinationals are internationally active. Significant contribution of increased exchange rate variability to systematic risk would imply that the cost of equity capital for these firms will increase relative to that of non-multinational (domestic) firms and that the additional risk due to exchange rate uncertainty has a significant impact on their value. Our results are easily summarized. By using a sample of 673 US multinational firms with real operations in the crisis-contaminated countries, we find that the stock return volatility of US multinational firms increases significantly in the aftermath of a financial crisis, even relative to the increase in stock return volatility for other US firms belonging to the same industry sector and market capitalization class that are not active in the crisis countries. The breakdown between systematic and diversifiable risk shows moreover that the stock market risk (β) of these US multinationals increases significantly during periods of increased exchange rate uncertainty. Finally, we demonstrate that the wholesale and retail trade, the transportation, communications and utilities as well as the finance and services sectors are particularly sensitive to exchange rate crises uncertainty. Small capitalization firms are likewise exposed to changes in the international trade environment. The remainder of the paper is organized as follows: after discussion our research design in Section 2, we describe the selected exchange rate crises and the nature of our sample procedures in Section 3. In Section 4, we examine the impact of increased exchange rate variability on US stock return volatility. In Section 5 the estimates of the extent to which US multinationals are exposed to financial crisis exchange rate uncertainty are presented and analyzed. Section 6 closes with some sensitivity analyses across industries and market capitalization classes. The final section concludes our findings.

We use firm- and industry-level stock returns to examine the changes in market risk for US multinational firms. In particular, we examine whether there is any relationship between fluctuations in foreign exchange rates and equity return volatility for US multinational firms, whether increased exchange rate variability contributes to their systematic risk (β) with respect to US equity market portfolio, and whether the impact of increased exchange rate risk displays any industry-specific or size-specific pattern? Using a sample of 673 US multinational firms with real operations in the crisis-contaminated countries, we find that the stock return volatility of US multinational firms increases significantly in the aftermath of a financial crisis, even relative to the increase in stock return volatility for other US firms belonging to the same industry sector and market capitalization class that are not active in the crisis countries. The breakdown between systematic and diversifiable risk shows moreover that the stock market risk (β) of these US multinationals increases significantly during periods of increased exchange rate uncertainty, whereas the control sample reveals no such evidence. Finally, we demonstrate that trade and services oriented industries are particularly sensitive to exchange rate crises uncertainty. Small capitalization firms are likewise exposed to changes in the international trade environment. The observed increased stock return volatilities and the corresponding increase in market risk have important implications for the decision-making process of international investors, as well as for firms in financial operations. This raises the issue of the firm’s cost of equity capital. If the additional risk imparted to exposed multinational firms from increased exchange rate variability is systematic in nature, it will affect the required rate of equity return to provide capital for the firm (investors demand higher returns for holding the its stock). Thus, US multinational firms with real foreign operations in the affected crisis countries saw their CAPM β rising as a result of the financial turmoil.