Report on the impact of real exchange rate on small, medium and large companies

Economic instability can imply volatility in GDP growth, inflation, interest rates, the exchange rate and other economic variables. The sensitivity of small, medium and large businesses to such swings varies according to the nature of their activities and the predominant form of their liabilities. Balance sheets of these businesses with heavy short-term debt may be particularly vulnerable to changes in short-term borrowing rates.

Companies with high foreign-denominated debt, which is not matched by currency revenues, are most sensitive to changes in the exchange rate, while for businesses with a large share of inflation-indexed domestic debt the biggest risk is from an unexpected increase in inflation. Analysis of the macroeconomic conditions for financial stability involves anticipating not only the most probable scenario at any time, but also the consequences of potential unexpected negative shocks.

When a company has its operations in more than one country it is exposed to exchange rate fluctuations which may impact its bottom line significantly, as companies are significantly expanding operations overseas so that they can exploit and gain from either labor arbitrage or expertise in functional areas or simply expanding market for their product they are exposed to fluctuations in the foreign exchange. Previous empirical studies have had a mixed reaction towards the relationship between the Exchange rate exposure and the stock prices and there has been no consensus towards the relationship.

Exchange rate exposure: A firm is exposed to fluctuations in the exchange rate when the value of its share is influenced by changes in the currency values (Michael Adler and Bernard Dumas (1984)). There are a number of ways through which the fluctuations in the exchange rate might affect the profitability of a firm and hence the stock prices. Those Firms who export to foreign countries (markets) may benefit from a depreciation of the local currency if its products become more affordable to foreign consumers.

While on the other hand, firms that source their raw materials from the foreign countries may see their profits shrink as a consequence of increasing costs of production. Even firms that do no international business may be influenced indirectly by foreign competition. Furthermore, firms in the non-traded as well as the traded sectors of the economy compete for factors of production, whose returns may be affected by changes in the exchange rate, although there are some explanations for the link between the fluctuations in the exchange rate and profitability, the link between the exchange rate and a firm’s stock price is less clear.

Under the Capital Asset Pricing Model, the expected risk premium on a company’s share price is proportional to its covariance with the market portfolio. In theory, investors will only require a return on the non-diversifiable portion of firm risk and no variable other than the market return should play a systematic role in determining asset returns. The classical Exchange rate Exposure theory states that depreciation in home country currency will help the home country firm and hurt foreign firms, Extensions that impact this theory include; consumer, supplier, competitor, and political reactions.

The Exchange rate exposure can be negated or toned down by hedging, firm hedges by taking a position that will rise in value to offset a drop in an existing position, such as, acquiring a cash flow, asset or contract. The financial theory states that the value of the firm is the NPV of the expected future cash flows and it says nothing about the certainty of the cash flows, the uncertainty that this class is concerned with are those associated with currency.

Types of exchange rate exposure: Transaction Exposure: The risk, faced by companies involved in international trade, those currency exchange rates will change after the companies have already entered into financial obligations. This kind of exposure to fluctuation inthe exchange rates can lead to major losses for firms. Economic Exposure: An exposure to fluctuating exchange rates, which affects a company’s earnings, cash flow and foreign investments.

The extent of the effect of the economic exposure of the firm depends on the specific characteristics of the company and its industry. Translation (accounting) Exposure: The risk that a company’s equities, assets, liabilities or income will change in value as a result of exchange rate changes. This happens when a firm issues or earns a portion of its equities, assets, liabilities or income in a foreign currency. Measuring economic exposure:

Economic exposure is the sensitivity of the future home currency value of the firm’s assets and liabilities and the firm’s operating cash flow to random changes in exchange rates there are many statistical tools to measure the sensitivity one of the ways is to run a regression analysis on the home currency and the currency that the firm is exposed to for example, If a U. S. MNC were to run a regression on the dollar value (P) of its British assets on the dollar pound exchange rate, S($/? ), the regression would be of the form: P = a +b*S +e

Where a is the regression constant and e is the random error term with mean zero. B the regression coefficient measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S. Exposure can be quantified in many ways such as Pro Forma, Regression/Historical Analysis or Simulation/Future Approach. Explanation of the model and methodology: To find the relationship between the Real exchange rates and stock prices the cointegration and granger causality for individual companies was conducted in the model this is explained as follows:

Univariate LM Unit Root Test: We begin through examining the stationary properties of the exchange rates and stock price series. Most existing studies of the relationship between exchange rates and stock prices use the Augmented Dickey-Fuller (ADF) or Phillips-Perron unit root tests to ascertain the order of integration of the series. A small issue with these tests is that neither allows for the possibility of a structural break, Perron (1989) showed that the power to reject a unit root decreases when the stationary alternative is true and a structural break is ignored.

Perron (1989) developed an ADF-type unit root test with one exogenous structural break and Zivot and Andrews (1992) developed an ADF-type unit root test with one endogenous structural break. Granger et al. (2000) and Hatemi-J and Roca (2005), which are two studies which examine the relationship between exchange rates and stock prices that use a unit root test with a structural break, employ the Zivot and Andrews (1992) and Perron (1989) unit root tests respectively. However, both of these tests have the limitation that the critical values are derived while assuming there is no break under the null.

Nunes et al. (1997) had shown that this assumption leads to size distortions in the presence of a unit root with a break. As a result, utilizing ADF-type tests one might conclude that a time series is trend stationary, when in fact it is non-stationary with a break, meaning that spurious rejections might occur. To examine the stationarity properties of the data for individual countries we employ the LM unit root test with one structural break proposed by Lee and Strazicich (2004).

In contrast to the Perron (1989) and Zivot and Andrews (1992) ADF-type unit root tests, the LM unit root test has the major advantage that its properties are unaffected by the existence of a structural break under the null (see Lee and Strazicich, 2001, 2004). Cointegration: Once the order of integration of each variable is ascertained, we test for cointegration. St = ? + ? Et + ut Where St and Et denote the natural log of stock index and exchange rate and ut is the error term. Gregory and Hansen (1996) propose three models for testing cointegration where they allow for the existence of a structural break in the cointegrating vector.