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In this paper we examine the relationship between exchange rate movements and firm value. We estimate the exchange rate exposure of publicly listed firms in a sample of eight (non-US) industrialized and emerging markets. We find that exchange rate movements do matter for a significant fraction of firms, though which firms are affected and the direction of exposure depends on the specific exchange rate and varies over time, suggesting that firms dynamically adjust their behavior in response to exchange rate risk. Exposure is correlated with firm size, multinational status, foreign sales, international assets, and competitiveness and trade at the industry level.

It is widely believed that changes in exchange rates have important implications for financial decision-making and for the profitability of firms. One of the central motivations for the creation of the euro was to eliminate exchange rate risk to enable European firms to operate free from the uncertainties of changes in relative prices resulting from exchange rate movements. At the macro level, there is evidence that the creation of such currency unions results in a dramatic increase in bilateral trade (Frankel and Rose, 2002). But do changes in exchange rates have measurable effects on firms? The existing literature on the relationship between international stock prices (at the industry or firm level) and exchange rates finds only weak evidence of systematic exchange rate exposure (see Doidge et al., 2003 and Griffin and Stulz, 2001 for two recent studies). This is particularly true in studies of US firm share values and exchange rates.2 The first objective of this paper is to document the extent of exchange rate exposure in a sample of eight (non-US) industrialized and developing countries over a relatively long time span (1980–1999) and over a broad sample of firms. We follow the literature in defining exchange rate exposure as a statistically significant (ex post) relationship between excess returns at the firm- or industry-level and foreign exchange returns. A key result from our analysis is the finding that exchange rate exposure matters for non-US firms. We find that for five of the eight countries in our sample over 20% of firms are exposed to weekly exchange rate movements and exposure at the industry level is generally much higher, with over 40% of industries exposed in Germany, Japan, the Netherlands and the UK.3 We find that there is considerable heterogeneity in the extent of exposure across our sample of countries as well as large variation in the direction and magnitude of exposure. Our analysis suggests that exchange rate movements do matter for a significant fraction of firms, although which firms are affected and the direction of exposure depends on the specific exchange rate and varies over time. Having established that there is a statistically significant relationship between profitability (as measured by stock returns) and the exchange rate, the second objective of the paper is to try to explain why some firms are exposed and others are not. We use the exposure coefficients estimated in the first part of the paper in a set of second-stage regressions to test three hypotheses about the factors that could explain exposure. The first hypothesis is that firm characteristics, namely firm size and its industry affiliation, are correlated with exposure. We find no evidence that exposure is concentrated in a particular sector, but we do find that small-, rather than large- and medium-sized firms, are more likely to be exposed. One rationale for this finding could be that larger firms have more access to mechanisms for hedging exposure than small firms, although data limitations do not allow us to test this conjecture directly. Our second hypothesis is that firms engaged in international activities are more likely to be directly affected by changes in exchange rates. We conjecture that multinational firms, firms with extensive foreign sales and firms with holdings of international assets are more likely to be exposed to exchange rate movements, and that they are likely to benefit from a depreciation of their home currency. In France, Germany, Japan and the UK we find evidence that measures of a firm's international activities are linked to exposure and the coefficient on the direction of exposure is indeed positive. Our third hypothesis is that firms engaged in trade are more likely to face exchange rate risk. Here, the direction of the exposure is more complicated. Exporting firms may benefit from a depreciation of the local currency if its products subsequently become more affordable to foreign consumers. On the other hand, firms that rely on imported intermediate products may see their profits shrink as a consequence of increasing costs of production due to a depreciating currency. One might expect, then, to find a correlation between exposure (positive or negative) and a firm's engagement in international markets. Lacking firm-level data on exports and imports, we use a number of proxies for a firm's relationship with international markets to test this hypothesis. We group firms into traded and nontraded sectoral categories to see if exposure is more concentrated in firms in the traded sector. Finally, we use data on bilateral trade flows at the industry level to examine the link between firm-level returns and bilateral, industry-level trade flows. Even firms that do no international business directly, however, could be affected by the exchange rate through competition with foreign firms. For example, if Ford Motor Company were to sell no cars abroad nor import any foreign auto parts, domestic automobile sales would still be affected if the dollar price of competing Japanese automobile imports falls or rises. We posit that exposure could depend on the competitiveness of a particular industry—in less competitive industries, prices are set farther from marginal cost implying higher mark-ups. In such industries firms will have some ability to absorb exchange rate changes by adjusting profit margins and lowering “pass through”. In more competitive industries we might expect close to perfect pass-through and therefore larger effects of exchange rate movements on stock returns.4 To test this hypothesis we examine the link between firm-level exposure and two OECD measures of market concentration, a Herfindahl index and a mark-up index. On a country-by-country basis we find only weak evidence that measures of trade and the degree of competitiveness of a particular industry are linked to firm-level exposure. Note that all of our measures used to test this hypothesis are industry-level indicators. It could be that there is sufficient heterogeneity in the trading patterns of firms within an industry that our industry-level variables simply do not reflect the impact of trade at the firm level. In our cross-country regressions, we find the industry-level export and import variables enter significantly and are correctly signed, suggesting that the additional variation in the cross-country trade data helps us better identify exposed firms. We also find that the Herfindahl index enters significantly in the cross-country regression; however, the sign on the coefficient indicates that firms in more concentrated industries are more exposed.5 Taken as a whole, our findings suggest that a significant fraction of firms are exposed to exchange rate risk in our sample of countries, but which firms are exposed changes over time. We do find a link between international activity and exposure, but for the vast majority of firms we are unable to identify the factors that account for their exposure. At first pass, this would seem to be a puzzling finding. If exchange rate movements matter for firms, why is it so difficult to identify the determinants of that exposure? On deeper reflection, however, it is not clear that there is a puzzle after all. Exchange rate exposure, as measured by the co-movement between exchange rates and excess returns, incorporates the effects of any hedging activity undertaken by the firm. Firms may use financial derivatives to help insure against exchange rate risk, or they may manage risk operationally by importing intermediate inputs from a number of suppliers, or by selling to an internationally-diversified consumer market.6 Indeed the finding that the subset of firms exposed to exchange rate movements is not stable over time is likely an indication that firms dynamically adjust their behavior in response to exchange rate risk. Viewed from this perspective, it would perhaps have been more puzzling to have identified a set of firms whose profits were consistently affected by movements of a particular exchange rate over a long span of time.7 The paper is organized as follows. The definition of exchange rate exposure is covered in Section 2 and Section 3 describes our dataset. The benchmark exposure results and the robustness of these results are discussed in Section 4. The second-stage results on the links between exchange rate exposure and other factors are reported in Section 5. Section 6 concludes.

We use firm- and industry-level stock returns to test for the presence of exchange rate exposure in eight countries. We find a significant amount of exposure to a range of different exchange rates. We find that at the country level, the extent of exposure is robust, although which firms are affected by movements in the exchange rate and the direction of exposure depends on the specific exchange rate and varies over time. We postulate that exchange rate exposure may be linked to a number of firm- and industry-level characteristics. Our second-stage regressions confirm that exposure is more prevalent in small- (rather than large- or medium-) sized firms and in firms engaged in international activities (measured by multinational status, holdings of international assets and foreign sales). We also find weak evidence linking industry-level measures of international trade and competitiveness to firm-level exposure. Our analysis of exposure suggests both that exchange rates have measurable effects on firms, and that firms adjust their behavior in response to exchange rate risk. Further, our results suggest that estimates of exchange rate exposure using industry-level data, or specific subsamples of firms that are “most likely” to be exposed, may well be biased downward, in that exposure seems not to be concentrated in specific industries and firms that are most susceptible to exposure are likely to actively hedge those risks.