Exchange Risk Sensitivity and Its Determinants: A Firm and Industry Analysis of U.S. Multinationals

Abstract

We develop a model of firm valuation to examine the exchange risk sensitivity of 409 U.S. multinational firms during the 1978-89 period. In contrast to previous studies, we find that exchange rate fluctuations do affect firm value. More specifically, we find that approximately sixty percent of firms with significant exchange risk exposure gain from a depreciation of the dollar. We also find that cross-sectional differences in exchange risk sensitivity are linked to key firm-specific operational variables (i.e., foreign operating profits, sales, and assets). Although we find limited support for exchange risk sensitivity when we aggregate the data into 20 SIC-based industry groups, we do observe some cross-sectional and inter-temporal variation in the exchange risk coefficients. Subperiod analysis reveals higher number of firms with significant exchange risk sensitivity during the weak-dollar period as compared to the strong-dollar period. • Exchange rate variability is a major source of macroeconomic uncertainty affecting firms in an open economy. Exchange rate fluctuations affect operating cash flows and firm value through the translation, transaction, and economic effects of exchange risk exposure. In addition, extemal shocks may create an interdependen ce between exchange rates and stock retums. Therefore, it is reasonable to expect a connection between exchange rate changes and firm value. The importance of exchange rate variability is also evidenced by the growing emphasis corporations place on exchange risk measurement and management strategies. However, compared to other macroeconomic factors, such as inflation and interest rate risk, the research on exchange risk and its impact on firm value is scant. Recent studies based on portfolio data (Bodnar and Gentry, 1993, Jorion, 1990, and Prasad and Rajan, 1995) and market-index data (Ma and Kao, 1990) have found minimal or no evidence of exchange rate fluctuations affecting stock retums. One explanation for these counterintuitive results is the research design used in these studies. We posit that, like any other