1. Unconditional and conditional exchange rate exposure.
18th Annual MFS Conference
Unconditional and conditional exchange rate exposure.
Ines Chaieb
University of Geneva & Swiss Finance Institute
Stefano Mazzotta,
Kennesaw State University

2. Outline Motivation Unconditional exposure Conditional exposure
Conclusion

3. Motivation FX risk is a major financial risk to nonfinancial firms
Significant amount of research on FX exposure
Theory suggests that firms should be exposed, but empirical studies find weak evidence
Focus is on cross sectional determinants
Foreign sales, leverage, liquidity, investment opportunities, derivative use
Two alternative explanations to the puzzling finding
Shortcomings methodology
Use of hedging (e.g. Bartram, Brown and Minton, 2007)
See, e.g., Jorion (1990), Bodnar and Gentry (1993), Amihud (1994), and Griffin and Stulz.

4. What we do in this paper
Examine exposure of U.S. firms unconditionally and conditionally
What drives the dynamic of exposure?
Does the business cycle affect FX exposure?
Do firm-specific circumstances affect FX exposure over time?

5. Unconditional Exposure; t = M J + E m R
"
Sample is U.S. firms from 1973:2 to 2005:4
4,265 firms, for a total of 194,000 data points from COMPUSTAT, clustered according to the 11 Fama and French industry classification.
Real exchange rate indices are the Major trading partners index (MJ) index and the Other important trading partners (EM) from the Fed

6. Replicating the puzzleo f m s w i h x p u I d y ( M J ) E N D b l 6 . 1 2 3 9 4 7 5 C 8 B q T V U S H O
We run firm by firm OLS regressions

7. Are we missing the forest for the tree?
Ines
Stefano

8. Unconditional Exposure I Firm-by-firm= M J + E m j R
" T a b l e 4 - P n A I d u s t r y M J S E N o D . 1 8 5 7 2 3 9 6 f c i g C h m B q p V U H O
Average of exposure of firm by firm regressions by industry, t-stats are the Fama MacBeth t-stats. Similar to Jorion we uncover significant estimates from the joint estimation.
SE indicates heterogeneous exposure of firms within same industry

9. Unconditional Exposure II Random Coefficient model – random effect on the slope; t = M J + E ( m ) R
" P a n e l B I d u s t r y M J i - E N o D b . 1 4 7 2 8 3 9 6 f c g 5 C h m q p T V U S H O

10. Results – Unconditional setup
Exposure to the MJ and EM currencies is statistically and economically significant for most industries
Negative exposure to MJ currency index and positive exposure to EM
consistent with US net importer from its major trading partners and net exporter to EMs
In absolute terms, the exposure to EM is larger in magnitude than the exposure to the MJ index

11. Conditional exposure Panel with instrumental variables; t = M J 1 + E
" : w h e K X j I V
Although there exist numerous variables that could be used to capture the changes in the macroeconomic environment, we focus on financial variables because they are available at the quarterly frequency and are not prone to measurement errors.

12. Instrumental variables
Macro variables
Macro financial instruments are the default premium (DP) yield difference between the U.S. Moody's AAA and BAA Corporate Bonds
Term spread (TP) is the difference between the U.S. 10 year Treasury with constant maturity and the U.S. 3-month T-Bill
Market total return
Robustness: PCA GDP, Industrial Production, Money supply (M2), Unexpected inflation (UI), the Export as proportion of GDP (Ex/GDP), the Import as a proportion of GDP (Im/GDP).
Firm Variables
The leverage is the ratio of debt over equity
Liquidity is quick ratio, (CA-INV)/CL
Robustness: proxies for size, growth opportunities, profit margin, degree of operating leverage
Although there exist numerous variables that could be used to capture the changes in the macroeconomic environment, we focus on financial variables because they are available at the quarterly frequency and are not prone to measurement errors.

13. Conditional Exposure IW a l d t e s f o r M j C u n c i J = 8
> m I V y  2 p v N D b . 9 6 1 5 3 7 4 g E h B q T U S H O

14. Conditional Exposure IIW a l d t e s E m r g i n M k C u c j = 8
> f I V o y  2 p v N D b 1 . 6 4 9 3 7 5 h B q T U S H O

15. Conditional results’ implications
Non Durables industry unconditional exposure coefficients MJ =
The coefficient for the term premium is highly significant.
Assume a decrease of one standard deviation in the term premium
a change in the exposure from to -0.62,
one percent real depreciation of the US dollar vis-à-vis the MJ index is associated with about 0.62 percent decline in excess returns, on average.
An increase of one standard deviation in the term premium
change in exposure from to 0.26
that a one percent depreciation of the US dollar is associated with an increase of 0.26 percent in excess returns, on average.
Unconditional measure of exposure could significantly understate or overstate the effect of exchange rates changes on stock returns
In the manufacturing industry for instance, the exposure coefficients on the MJ and EM currency indices are respectively MJ = and EM = Assuming a one percent real depreciation of the dollar against major and emerging market trading partners simultaneously, the total average impact on the returns would be negligible as the exposures would offset each other. However this implicitly amount to assuming that the two currency indices are perfectly correlated while they are not as evidenced by the low correlation of 0.23

16. Concluding remarks US firms are significantly exposed to FX risk
Exposure is significantly time-varying
The dynamics of exposure are mainly driven by macro financial variables
The dynamics are such that exposure increases in contractions
Unconditional measure of exposure could significantly understate or overstate the effect of exchange rates changes on stock returns

17. FX exposure changes substantially across industries and over time and often changes sign. Exposure increases in periods of contractions