Imports, Exports, Dollar Exposures, and Stock Returns

Abstract

Economic theory suggests that the magnitude and direction of a company’s currency risk exposure depends crucially on its fundamental involvement in international trade. For U.S. industries, we find that the stock performance of import-oriented companies moves positively with the performance of the dollar, but the stock performance of export-oriented companies tends to move against the dollar. Based on this finding, we use the imports and exports information to enhance the identification of the dollar risk exposure for different industries, and analyze how each industry’s expected stock return varies with its dollar risk exposure. We identify a strongly negative risk premium for bearing positive exposures to the dollar. On average, import-oriented companies generate lower expected stock returns. We also find that the risk premium becomes more negative during recessions than during expansions.Our strong findings rely on three major insights. First, it is not the aggregate trade activity but rather the unhedged trade imbalance between imports and exports that generates the currency exposure. Second, cross-sectional variations in business characteristics and hence risk exposures are much larger than intertemporal variations within a fixed industry. Third, the lack of significance in risk premium estimates is often due to measurement errors in the risk exposure estimates. The first insight leads us to include imports and exports as separate explanatory variables; the second insight motivates us to use cross-sectional regressions instead of time-series regressions to identify the linkage between currency risk exposures and trade fundamentals; and the third insight motivates us to sharpen the risk exposure identification by incorporating economic fundamentals, with which we obtain a significant risk premium estimate on the dollar exposure.