Resolving the Exposure Puzzle: The Many Facets of Exchange Rate Exposure

Abstract

Theoretical research predicts many firms should have sizeable exchange rate exposure. However, empirical research has not documented consistently strong relations between exchange rates and stock prices. To examine this discrepancy, we extend prior theoretical results to model a global firm's exchange rate exposure. Using this model and a global sample manufacturing firms from 16 countries, we show empirically that firms pass part of currency changes through to customers, utilize operational hedges (e.g., matching foreign sales with foreign production), and employ financial risk management strategies. We estimate that for a typical firm in our sample, pass-through and operational hedging each reduce exposure by 10% to 15%. Financial hedging with foreign currency debt, and to a lesser extent FX derivatives, appears to reduce exposure by about 40%. The combination of these factors reduces exchange rate exposures to observed levels.

Keywords: Competition, hedging, exposure, derivatives, corporate finance, international finance

JEL Classification: G3, F4, F3