The Time-Varying Exposure of Firms to Exchange Rate Volatility By Julio Huato1 , Jason Hecht2 , Mihail Velikov3 , and Belyana Semeran4 June 2, 2009 Motivation High exchange rate volatility, a pervasive phenomenon in the post-Jamaica Agreement (1973) international monetary environment, has reached new heights during the global financial crisis of the last three years. Although the U.S. dollar experienced a pronounced depreciation between the spring of 2002 and the spring of 2008, large imbalances in the international financial position of the United States vis-à-vis the Asia-Pacific and Gulf-region countries remain and, since the summer of 2008, as a result of the global flight to safety, these imbalances have partially regained some of its lost ground. (Bergsten, 2009.) In this context, the size, evolution, and sources of exposure to unexpected changes in the exchange rates as well as the hedging practices of firms have become topics of considerable interest in the financial literature. However, a key issue not adequately addressed in the literature is whether and to what extent firms are learning, adapting their behavior to better manage their foreign exchange risk. Exposure need not be static, but may shift over time. Yet, traditionally, exposure measures are estimated as time fixed coefficients. This project uses the Kalman filter estimation of time varying betas to circumvent this deficiency. It has been conjectured (Dominguez and Tesar, 2006) that over time firms adjust their behavior in response to foreign exchange risk. Awareness of foreign exchange risk has increased, as evidenced by the growing interest in forex exposure in the literature, the refinement of exposure management techniques, and the boom and recent recoil in forex derivative contracts. Should we expect, then (assuming the firms’ preference for risk does not change), the size of exchange rate exposure to decline over time? A compelling argument in defense of non-floating foreign exchange arrangements – from pegging, to currency boards, to monetary unification – holds that, not only hedging foreign exchange risk is costly when available, but that economic agents are slow or – in many cases – unable to hedge. Clearly, if the most financially sophisticated firms in the emerging countries – those publicly traded – are perceived by the market to be highly exposed and the size of their perceived exposure exhibits no discerning (declining) trend over a recent 8-year period, this type of argument is strengthened. This project sets out to estimate the exposure of publicly-traded firms in various emerging markets to unexpected changes in the exchange rate, trace out its evolution over the 2000-2008 period, and quantify the effect of country- and industry-specific factors on said exposure. 1 St.
Francis College, juliohuato@gmail.com College of New Jersey, jayhecht@gmail.com 3 Ramapo College of New Jersey, velikov.mihail@gmail.com 4 Wachovia Securities, bsemeran@yahoo.com 2 Ramapo
Goal This project sets out to (1) estimate the exposure of a large set of firms in a large number of markets to changes in the exchange rates and (2) trace out the evolution of this exposure over time. Data sources The data on daily (close) prices adjusted for dividends of our set of emerging markets firms are drawn from various databases aggregated by Thomson One Banker. The daily exchange rates are drawn from the Federal Reserve Board of Governors and the European Central Bank web sites. The data on the market portfolio prices are from the daily MSCI World Daily Index. The time series cover from 1/3/2000 to 5/27/2008. Methodology The typical approach to measuring exposure starts by presuming that a relatively simple assetpricing theoretical structure (e.g. CAPM, APT, or EUM) governs the generation of the data. Under the typical theoretical structure, both the firm’s equity and the exchange rates are treated as covariate asset prices and their pattern of covariation is viewed as determined jointly, although with different effects on each asset price, by changes in monetary policy and, more generally, shifts in the overall economic environment (Allayannis and Ofek, 2001; Bartov and Bodnar, 1994; Jorion, 1990; Adler and Dumas, 1984). Along the lines of Martin and Mauer (2005) and Koutmos and Martin (2003b), this project will test, analyze, and report results from both the traditional time fixed coefficient estimation and the Kalman filter time varying coefficient estimation. In the first step, the main regressor in the study, namely the unanticipated component of the change in the exchange rates, is estimated by presuming that the evolution of exchange rate follows a simple martingale process of the type: St = St−1 + Xt where St is the logarithm of the exchange rate level at t and X is the unexpected or innovation component with Et−1 (Xt |St−1 ) = 0.5 In the second step, a general model of the following form is estimated, where the relevant betas are alternatively assumed to be time fixed and time varying: q
Rit = β0 + βm Rmt + ∑ βX1l Xlt + uit l=1
where Rit is the percent change in value (market return rate) or cash flow of unit i in period t; Rmj is the standardized “market” return raised to the j-th power; l = 1, . . . , q denotes a particular foreign currency, and u is the error term. Clearly, ui can be interpreted as a measure of unitspecific or “diversifiable” risk. 5 Due
to data availability, we cannot experiment with one-period ahead forward rates, Ft+1 assuming them to be the best unbiased predictor of St . There are no active forward or future markets in many of the market currencies under study.
Expected Outcomes The expected outcomes are four completed drafts ready for submission to academic journals. Two of the drafts are scheduled for completion by the end of the summer of 2009 and the remaining two by the spring of 2010. The drafts will report and analyze results for, respectively, (a) U.S. companies, (b) other OECD country companies, (c) China, India, Brazil, and Russia, and (d) all other emerging markets. The target journals include the Global Business and Finance Review, International Finance, the European Journal of Finance, the Journal of International Money and Finance, Asia-Pacific Financial Markets, Multinational Business Review, the North-American Journal of Economics and Finance, and the Quarterly Review of Economics and Finance. Four regions [and papers]: (1) East Asia (China, India, Pakistan, Philippines) [Julio Huato and Mihail Velikov]; (2) North-America (U.S., Canada, Mexico) [Julio Huato, Jason Hecht, and Mihail Velikov]; (3) Africa (Egypt, Morocco, South Africa, Zimbabwe) [Julio Huato and George Gonpu]; (4) South America (Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela) [Julio Huato and Jason Hecht]; (4) Central Asia, Middle East, and Eastern European countries (Czech Republic, Hungary, Israel, Jordan, Poland, Russian Federation, Slovakia, Turkey) [Julio Huato and Belyana Semeran]. We may pursue a further study of big markets (U.S., Euro region, Japan, Canada, Australia, New Zealand). Then, the expected intellectual contribution is a paper to be submitted for publication to – alternatively – the Journal of Applied Finance, Financial Management, or similar top journal.
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