EXCHANGE RATE AND STOCK RETURNS

Investigate the Effects of Foreign Exchange (FX) Rate Changes on Stock Returns of Industrial Firms or Financial Institutions

Investigate the Effects of Foreign Exchange (FX) Rate Changes on Stock Returns of Industrial Firms or Financial Institutions

Introduction

Even though financial theory predicts sizable foreign exchange rate exposures for many firms, a large literature has documented that empirically the impact of exchange rate risk on stock returns is economically and statistically small in almost any sample.2 While it might be possible to reconcile the empirical evidence with predictions from theory by considering various forms of corporate hedging that reduce large gross exposures of firms to levels that are small on an after-hedging basis, the question remains whether empirical estimates of exchange rate exposures are, despite being small, still economically meaningful and useful for investors in financial markets.

In this paper we address this issue. To this end, we argue and show that tests of the relation between stock returns and exchange rate exposure are fraught with similar problems revealed by Pettengill et al. (1995) and Lakonishok and Shapiro (1984) with regards to the conditional relation between stock returns and market betas. Tests of the relation between market betas and future returns postulate ex ante a positive, unconditional relation between expected returns and market betas. However, these papers propose that the relation between realized returns and market betas is segmented, i.e. positive in periods of positive market excess returns and negative in periods of negative market excess returns. This conditional relation entails that market betas may not show a significant relation with returns in standard Fama and MacBeth (1973) regressions since the existence of a large number of periods with negative market excess returns biases test of a positive unconditional relation between market betas and returns against finding a systematic relationship.

Since positive and negative exchange rate changes occur with roughly the same frequency and since the average currency premium is close to zero, empirical tests are even more biased against finding a positive unconditional relation than for market betas. Consequently, we argue that the relation between stock returns and exchange rate exposure should be examined conditional on the realization of the exchange rate change, i.e. positive for local currency depreciations and negative for local currency appreciations, while the unconditional relation is likely insignificant on average, just as for market betas. We test these predictions of the relation between exchange rate exposure and stock returns for a large sample of non-financial firms from 37 countries, both developed and emerging. In line with our predictions, we fail to find an unconditional relation between stock returns and ex-ante exposure suggesting the lack of a relation between exposure and expected return, but document a conditional relation that is a direct function of the realization of the exchange rate factor, suggesting that exchange rate exposures matters for realized returns.

Aims of the Study

Investigate the effects of foreign exchange (FX) rate changes on stock returns of industrial firms or financial institutions and test the sensitivity of the ...