Old Dominion University ODU Digital Commons Theses and Dissertations in Business Administration College of Business (Strome) Fall 1995 Non-United States Firms' Exchange Rate Exposure and the Pricing of Exchange Rate Risk in Foreign Stock Markets Patricia Hill Hamlin Hall Old Dominion University Follow this and additional works at: https://digitalcommons.odu.edu/businessadministration_etds Part of the Finance and Financial Management Commons Recommended Citation Hall, Patricia H.. "Non-United States Firms' Exchange Rate Exposure and the Pricing of Exchange Rate Risk in Foreign Stock Markets" (1995). Doctor of Philosophy (PhD), Dissertation, , Old Dominion University, DOI: 10.25777/va2h-mm13 https://digitalcommons.odu.edu/businessadministration_etds/105 This Dissertation is brought to you for free and open access by the College of Business (Strome) at ODU Digital Commons. It has been accepted for inclusion in Theses and Dissertations in Business Administration by an authorized administrator of ODU Digital Commons. For more information, please contact [email protected]. Old Dominion University The Graduate School of Business Administration NON-US FIRMS' EXCHANGE RATE EXPOSURE AND THE PRICING OF EXCHANGE RATE RISK IN FOREIGN STOCK MARKETS A Dissertation in Business Administration by Patricia Hill Hamlin Hall Submitted in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy in Business Administration We gratefully acknowledge the generosity of Datastream International in providing the data. Copyright 1995 September 1995 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. We approve the Dissertation of Patricia Hill Hamlin Hall Date of Signature John Doukas llrofessor of Finance Dissertation Advisor Chair of Committee Moha~ed ?¢ajand Associate Professor of Finance Carol A. Markowski Professor of Decision Sciences and Management Information Systems Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ACKNOWLEDGEMENTS I wish to sincerely acknowledge the members of my Dissertation committee, Dr. John Doukas, Dr. Mohammed Najand, and Dr. Carol Markowski. They provided constant support and encouragement during the development and writing of this Dissertation. As chair, Dr. Doukas has always held me to the highest standards for which I will always be grateful. I would also like to acknowledge other members of the academic community, Dr. Bruce Seifert, Dr. Bruce Rubin, Dr. Sylvia Hudgins, Dr. Vined Agarwal, and Dr. Mary Cutler. They have conveyed to me a comprehensive knowledge of Finance, as well as a joy for the process of learning. Lastly, my heartfelt thanks go to my parents, to my sisters, and to my friends without whose support this effort could not have been realized. It is with great pride that I dedicate this Dissertation to my children, Del, Emily, and Catherine. It has only been through their understanding and love that I have had the freedom to recognize my abilities and to attain this doctoral degree which means so much to me. My sincerest wish is that they too are able to achieve their dreams. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE OF CONTENTS ESSAY ONE ABSTRACT I. Introduction II. Literature Review a. Previous Theoretical Literature b. Previous Empirical Studies ID. Exchange Rate Exposure a. Domestic Firms b. Exporting Firms c. Multinational Firms IV. Data Description Table I - Summary of Sample Size V. Methodology VI. Empirical Evidence Table II - Economic Exposure of Domestic Firms Table ill - Economic Exposure of Low Exporting Firms Table IV - Economic Exposure of High Exporting Firms Table V - Economic Exposure of Multinational Firms Table VI - Individual Firms Reporting Significant Economic Exposure Table VII - Percent Foreign Sales to Total Sales as a Determinant of Economic Exposure VII. Concluding Remarks and Implications REFERENCES APPENDICES A. Country Portfolios B. Criteria for MNC Classification C. Trade Data from Europa Yearbook D. Results from Domestic Market Index and World Market Index Tests Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ESSAY ONE ABSTRACT This study examines the economic exposure of finns from four foreign countries; Gennany, the United Kingdom, Japan, and Canada. Finns are classified as purely domestic firms,. low exporting finns, high exporting firms, and multinational firms in an attempt to discover systematic detenninants of economic exposure effects. We find that while purely domestic and low exporting firms are not typically exposed to exchange rate changes, high exporting and multinational firms are. Although the level of this exposure varies across exchange rates, it is consistently positive. The firm's percent foreign sales to total sales is a significant determinant of this exposure. We also find that country specific domestic market indexes explain more of the various sample variances than a world market index. I. INTRODUCTION The market value of the firm is a major issue in the study of finance. While there are many factors which influence the market value of the firm, this study focuses on the influence of changes in exchange rates on the firm's value. As global financial and product markets become increasingly more integrated, the effect of changes in exchange rates has taken on greater significance to both corporate management and investors. Foreign exchange rate exposure is often analyzed in three distinct forms; ( 1) translation exposure, (2) transaction exposure, and (3) economic exposure. While both transaction and translation exposure are relevant to the firm in the short run, economic exposure reflects the firm's overall sensitivity to changes in exchange rates. Without discounting the importance of the other two fonns of exposure, economic exposure must be considered the most relevant as it impacts the firm's cash flows and hence its long run profitability. Exchange rate volatility influences cash flow fluctuations, which in tum may effect the market value of the firm and consequently produce changes in stockholder wealth. As financial theory dictates that the goal Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2 of the firm is to maximize shareholder wealth then the understanding and management of exchange rate economic exposure is of prime importance to corporate management. The focus of this study is thus on economic exposure, which is defined as the change in the market value of the firm, based on changes in future cash flows, due to unexpected changes in exchange rates. As market e~posure reflects the sensitivity of a firm's value to changes in overall market conditions, economic exposure measures the sensitivity of the firm to changes in exchange rates. In neither case does exposure imply a causal relationship, but rather a historical correlation. The statistical discovery of economic exposure is therefore founded upon the identification of the detenninants of that exposure. Previous theoretical and empirical works have suggested alternative potential determinants of economic exposure. Deviations from purchasing power parity, levels of demand (in)elasticities, degree of export or import dependence and the firm's primary industrial classification have all been studied as determinants of economic exposure. 1 This study incorporates the findings of these earlier studies and extends them through an original sample selection process which uses only foreign (non-US) firms. Jorion (1990) examines exchange rate economic exposure as a function of the degree of foreign operations, which is measured as the ratio of the firm's foreign sales to total sales. Using primarily US firms, he finds evidence of a positive relationship between the degree of foreign operations and exchange rate exposure. His strongest results, however, are with his one sample of foreign firms which exhibit the greatest degree of economic exposure. These results suggest that foreign firms are more likely to be exposed to changes in exchange rates than US firms and 1 These potential determinants are described at length in the literature review, b:it essentially are reflected in the works of Hodder (l 982), Levi (1983), Choi (1986), Luehrman (1990), and Jorion (1990, 1991). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3 consequently any cross-sectional differences in exchange rate exposure might be more pronounced for foreign firms. This study uses a sample of foreign firms in an attempt to investigate this possible connection. We extend Jorion's measure of "foreign operations" to classify firms by their primary trading activity. Foreign firms are categorized as primarily purely domestic firms, as exporting firms, or as Multinational finns (MNCs). The use of this sample selection process, applied only to foreign finns, may allow for the detection of systematic influences of exchange rates changes not readily discemable using US data. This study also extends previous studies in that more than one exchange rate is utilized. Exchange rates represent the value of a country's currency relative to another currency and consequently it may be possible to find a differential sensitivity of the firm's value to different rates. This study uses bilateral rates against the US dollar, the ECU, the SDR, and a country specific trade weighted exchange