Exchange Rate and Interest Rate Exposure of UK Industries Using Ar(1)- Egarch-M Approach

Abstract

Exchange rate and interest rate risk have been documented as the most managed financial risks by most UK non-financial firms and industries. This is probably because of the severe adverse effects that contrary movements in these financial risks can have on the value of the firm or industry. Nevertheless, empirical studies on these risks have been very few and predominantly limited in scope. Therefore, using a sample of 402 UK non-financial firms from 31 industries, over the period January 1990 to December 2006, this study examines the relevance of these financial risks on the stock returns of firms and industries. Following the weaknesses of the Ordinary Least Square (OLS) methodology, the AR(1)EGARCH-M model was subsequently used for the estimation. The results indicated that the stock returns of UK industries were more affected by long-term interest rate risk than exchange rate risk (Trade weighted index, US$/£ JP¥/£) or even short-term interest rate risk. Additionally, by means of the Herfindahl index as a measure of industry concentration, competitive industries were found to exhibit a higher degree of exposure to movements in exchange rates and interest rates, and also higher volatility in returns than industries that were classified as concentrated. Finally, it was also found that for most UK industries: increased risk did not necessarily lead to an increase in returns; severe adverse movements in exchange rates and interest rates can potentially make returns more volatile; volatility of returns has time varying properties; and the persistence of volatility is much higher in some industries than others.