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Abstract
Using weekly data obtained from three emerging market economies, this study looks into the time-varying characteristic of exchange rate exposure coefficients. In doing so, unlike in some previous studies, exchange rate exposure is viewed through the eyes of an investor in the relevant country. The analysis is carried out using country-level stock indexes and trade-weighted exchange rates. Time-varying exchange rate exposure coefficients are obtained by estimating a multivariate BEKK-GARCH-M model with explicit focus on the non-orthogonality between exchange rate changes and market returns. The findings of the study indicate that, although they are likely to vary over time, exchange rate exposure coefficients of two out of the three cases follow mean-reverting long-memory processes. The presence of mean-reverting exchange rate exposure coefficients has important implications for investment and hedging strategies. In addition, time-varying exchange rate exposure coefficients turn out to be more volatile than respective market betas.
Highlights
The exposure of firms’ profits to exchange rate changes, commonly known as exchange rate exposure, is three- fold: accounting, transactions and operating exposure
The first such test is the cumulative sum of squared recursive residuals (CSSRR) test suggested by Brown et al (1975)
A trivariate BEKK-GARCH (1, 1, 1)-M model based on a conditional ICAPM framework has been used to obtain time-varying exchange rate exposure betas
Summary
The exposure of firms’ profits to exchange rate changes, commonly known as exchange rate exposure, is three- fold: accounting, transactions and operating exposure. Transaction exposure refers to the changes in the value of the cash flows that stem from contracts entered into prior to a change in exchange rates and to be received/paid after the change in exchange rates. Operating exposure refers to the change in a firm’s future operating cash-flows caused by unexpected changes in exchange rates. The second and third elements of exposure are mostly considered together in the literature and are jointly called economic exposure. Following this common practice, the term ‘exchange rate exposure’ in this study refers to the two components known as ‘economic exposure.’
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