Crossing the Lines: The Conditional Relation Between Exchange Rate Exposure and Stock Returns in Emerging and Developed Markets

Söhnke M. Bartram, Gordon M. Bodnar
2010 Social Science Research Network  
This paper examines the importance of exchange rate risk in the return generating process for a large sample of non-financial firms from 37 countries. We argue that the effect of exchange rate exposure on stock returns should be conditional and show evidence of a significant return premium to firmlevel currency exposures when conditioning on the exchange rate change. The return premium is directly related to the size and sign of the subsequent exchange rate change, suggesting fluctuations in
more » ... fluctuations in exchange rates themselves as a source of time-variation in currency risk premia. For the entire sample the return premium ranges from 1.2 -3.3% per unit of currency exposure. The premium is larger for firms in emerging markets, while in developed markets it is statistically significant only for local currency depreciations. Overall, the results indicate that exchange rate exposure plays an important role in generating cross-sectional return variation. Moreover, we show that the impact of exchange rate risk on stock returns is predominantly a cash flow effect as opposed to a discount rate effect. Abstract This paper examines the importance of exchange rate risk in the return generating process for a large sample of non-financial firms from 37 countries. We argue that the effect of exchange rate exposure on stock returns should be conditional and show evidence of a significant return premium to firmlevel currency exposures when conditioning on the exchange rate change. The return premium is directly related to the size and sign of the subsequent exchange rate change, suggesting fluctuations in exchange rates themselves as a source of time-variation in currency risk premia. For the entire sample the return premium ranges from 1.2 -3.3% per unit of currency exposure. The premium is larger for firms in emerging markets, while in developed markets it is statistically significant only for local currency depreciations. Overall, the results indicate that exchange rate exposure plays an important role in generating cross-sectional return variation. Moreover, we show that the impact of exchange rate risk on stock returns is predominantly a cash flow effect as opposed to a discount rate effect. "The key but far from straightforward question is of course "how much" exchange rate movements matter." Exchange rate moves in a global A fundamental issue in modern global finance is the degree to which exchange rate fluctuations influence firms' stock returns. Of course changes in exchange rates can affect stock returns either by altering firms' expected cash flows or the cost of capital used to discount these cash flows. Previous work has been done on both of these dimensions. One branch of research has looked at the pricing of exchange rate risk in formal asset pricing models, but the results are mixed (e.g., Roache and Merprovide support for the existence of a time-varying risk premium for exchange rate risk using conditional pricing models, but offer little insight into the expected size of the premium or the source of its time variation. More recently Francis et al. (2007) show evidence of a time-varying currency premium for U.S. industries that they estimate adds about 2.47% to the cost of equity and accounts for approximately 11.7% of the total risk premium in absolute value. However, they are unable to trace the premium down to the level of the firm. Another branch of research on this broad question looks at the sensitivity between exchange rate changes as stock return and focuses on estimating exposures (e.). These studies demonstrate that the past distribution of firm returns is to some degree related to exchange rate changes; however, they tend to focus on identifying corporate variables that explain the cross sectional variation in exposures. What is less commonly examined in this line of research is the relation between the firm-level exposures and subsequent stock return performance. This paper investigates the importance of exchange rate exposure in the firm-level stock return generating process using a large sample of non-financial firms from 37 countries, both developed and emerging, over the period 1994 -2006. We argue for the existence of and document a conditional relation between stock returns and their sensitivity to exchange rates where the variation is directly related to the realization of the exchange rate factor. Our results demonstrate that the product of the firm's historic exposure and the subsequent exchange rate change play a significant
doi:10.2139/ssrn.1077674 fatcat:l5ziicsf4vd5hijzjbiutjxbee