Modeling exchange rate exposure in the Japanese industrial sectors

Abstract

In recent years the volatility of exchange rate exposure and its associated risk have become a hot issue in international financial management. It is often assumed that a firm's future operating cash flows is proxied by its market value, and the exposure coefficient would be able to efficiently measure the impact of exchange rate changes on a firm's return and its sensitivity to the changes. Recently, some studies begin to investigate whether exchange rate exposure is asymmetric between currency appreciations and depreciations. By far most existing studies on exchange rate exposure assume that the variances of a firm's returns and exchange rates changes are time-invariant. In this paper, we assess empirically the validity of this assumption, and argue that the conveniently defined exchange rate exposure is inadequate for measuring the entire impact of exchange rate changes on a firm's future operating cash flows in cases of time-varying variances. There are at least four alternative routes through which a firm's returns are exposed to foreign exchange risks when the variances are time-variant. The four aspects of exchange rate exposure or the multi-elements of exchange rate exposure are defines as follows: • the first route is that a firm's stock returns are exposed to the exchange rate changes either directly or indirectly through its business linkages with other firms. • the second route captures the exposure to the volatility of exchange rate changes, namely, the sensitivity of a firm's value to the degree of fluctuations of exchange rates. If the degree of fluctuations is time-varying, the firm may react to change its marketing, production location and hedging strategies. • the third level of exchange rate exposure measures the sensitivity of conditional variance of the returns to the volatility of exchange rate changes. Even if the second relationship is absent, as long as the conditional variances of returns are exposed to volatility of exchange rate changes and the returns are sensitive to its own volatility changes, there still exists the possibility of an indirect impact of exchange rate volatility on returns. As a consequence, the firm may have to re-assess and even change its current business strategies which may in turn affect its profitability. • The fourth route indicates the time-varying conditional correlation between returns and exchange rate changes, through which the dynamics of a firm's exchange rate exposure will be captured. We employ the bivariate GJR-GARCH-M models to investigate the four aspects of exchange rate exposure, by using data of the daily industrial indexes of ten sectors in Japan during the period from 1992 to 2000. The results indicate that there are cases which are not exposed to currency risk under the conventional measure (exposure coefficient), but significantly exposed to currency risk through the alternative routes identified we find significant evidence of such exchange rate exposure which is not captured by the conventional measure. The diagnostic statistics confirm the adequacy of our model, and hence the robustness of the results.