Exchange Rate Movements in Economic Integration

Variability in foreign exchange (FX) rate has been one of the major economic and financial factors affecting cash flows and common stocks value. After the collapse of post-war Bretton Woods fixed exchange rates in the 1970’s, the relative prices of currencies began to fluctuate. The rapid expansion in international trade and adoption of floating exchange rate regimes by many countries led to increase exchange rate volatility.

As economic integration and globalization have been increasing year by year, exchange rate movements have become very important source of risk for financial firms as well as non-financial firms. In this context, it is very important to mention that virtually all existing empirical studies estimate currency exchange rate exposures on the basis of share prices. However, the assessment of cash flow and stock price exposures which will be studied in this research will represent a rational alternative to the analysis of stock price exposures. In fact, it is the impact of exchange rate risk on corporate cash flows rather than equity prices per se, that is emphasized in the theoretical literature on corporate risk management, either for tax reasons, managerial performance, bankruptcy, investment decisions or compensation purposes.

Jacque (1996) points out that change in a company’s earnings due to unexpected foreign currency exchange rate changes relatively to their domestic currency is considered as foreign exchange rate risks. Changes in exchange rates may affect firms’ profitability and value. Exchange rate changes can also impact on the level of competitiveness of the firms which are exposed to exchange rate risk, or affect the value of their net assets denominated in foreign currencies.

Adler and Dumas (1984) show that even firms whose entire operations are domestic may have affects of exchange rates of foreign currencies, if their output and input prices are influenced by currency movements.

Moreover, Eiteman et al. (2006) says that in general, firms are exposed to three types of foreign exchange risk: translation exposure, transaction exposure and economic exposure. In practice, economic exposure is computed as the net sensitivity of some aggregate measure of firm value to currency fluctuations. Economic exposure contains of the direct and indirect effects of currency fluctuations by focusing on the net sensitivity. In practice, there is little general agreement on the use of appropriate choice of ‘‘aggregate” measure. In this research project it is focused on the impact of economic exposure of Malaysian non-financial firms (from consumer products industry) on their values. Corporate managers will also be interested in the exposures of corporate cash flow measures such as sales, operating cash flow and earnings for reasons of corporate planning and risk management.

Problem statement

As economic integration and globalization have been increasing year by year, exchange rate movements have become very important source of risk for financial firms as well as non-financial firms.

Also, the internationalization of capital markets has resulted in inflow of vast sums of funds between countries and in the cross listing of equities. This has therefore made investors and firms more interested in the volatility of exchange rate and its effect on stock price and stock market volatility. According to Yucel and Kurt (2003), floating exchange rate appreciation reduces the competitiveness of export markets; and has a negative effect on share prices as well as the domestic stock market. On the other hand, for import dominated country, it may have positive effect on the stock market by lowering input costs.

Malaysia presents an example of an open economy which engages in international trade with several countries and hence susceptible to foreign exchange rate volatility.

However, empirical evidence on the influence of foreign exchange market volatility on stock market is largely inconsistent. These have been in the contest of developed economies. Mishra (2004) found no theoretical consensus on the interaction between stock prices and exchange rate. However, Solnik (2000) argues that there is a negative correlation between stock market and local currency.

The openness of a country’s economy is recognized as a cause of volatility of its market. Malaysia presents a classic example of an open economy which engages in international trade transaction. Moreover, with advert of globalization, developing economies are becoming more integrated into developed economies as the results of increasing flow of imports and exports. Malaysia is not an exception. A cursory examination of foreign exchange rate history in Malaysia shows some considerable level of volatility. Therefore, it would be interesting to explore the effect of its foreign exchange volatility on cash flows as well as stock prices of its non-financial companies. Again, much work on the effect of the exchange rate volatility in the developing country like Malaysia has not been done. Thus, for that reason the study intended look at the effect of foreign exchange exposure on non-financial companies’ cash flows and stock prices in Malaysia.

Research objectives

Objective of the current research is to determine whether cash flows and stock prices of companies from consumer products industry are affected by exchange rate exposure. This research project attempts to assess the economic exposures of the firms chosen from the Bursa Malaysia Main market. The issues are important for investors as well as corporate risk management. The research aims to find answers to the following questions:

• Are cash flows of the companies exposed to exchange rate risk?
• Are stock prices of the companies exposed to exchange rate risk?
• Which currencies have major influence on the companies’ cash flows?
• Which currencies have major influence on the companies’ stock prices?

Literature review

It is also noticeable whether the firms’ cash flows are sensitive to exchange rate movements. Perhaps we should also point out the fact that Grambovas and McLeay (2006) are convinced that empirical analysis confirm that currency fluctuations may affect firm values, especially with consideration to the influence of foreign exchange rate movements on the firms’ cash flows and their accounting earnings, and on their stock prices.

Martin and Mauer suggest that economic exposure, which typically has a longer-term time dimension, encompasses the competitive and indirect effects of exchange rate risk. Many academics such as Hodder (1982), Marston (2001) Pringle (1995), Shapiro (1975) and von Ungern-Sternberg & von Weizsacker (1990) argue that unlike transaction exposure, economic exposure can affect even domestic firms. Economic exposure arises from changes in the sales prices and volumes, and the cost of inputs of the firm and its competitors as a result of exchange rate changes. Miller & Reuer (1998) and Sundaram & Black (1992) argued that geographically positioning production, sales, sourcing, and financing operations is effective for reducing economic exposure.

The study by Söhnke M. Bartram (2007) found significant exposure of several firms to at least one of the foreign exchange rates, and significant exposures found by them were more frequent at long-term horizons. They also argue that the impact of exchange rate risk on share prices and cash flows is similar and determined by a correlated set of economic factors.

Moreover, Dominguez and Tesar (2006) found that exchange rate movements do matter for a significant fraction of firms, though which firms are affected and the direction of exposure depends on the specific exchange rate and varies over time, suggesting that firms dynamically adjust their behavior in response to exchange rate risk. Exposure is correlated with firm size, multinational status, foreign sales, international assets, and competitiveness and trade at the industry level.

Martin and Mauer (2003) pointed out that cash flow effects are greater for long-term lags than for short-term lags in exchange rate movements. This result may occur because transaction exposure is easier to assess and hedge, whereas economic exposure is more difficult to recognize and hedge. While Bartram (2007) suggests significant exposure of several firms to at least one of the foreign exchange rates such as CAD, JPY and EUR, and significant exposures determined by Bartram (2007) were more frequent at long-term horizons. The percentage of firms observed for which stock price and earnings exposures were considerably different was relatively low, though it increased with time horizon. Finally, he was convinced that the impact of exchange rate risk on stock prices and cash flows is similar and determined by a related set of economic factors.

Batram and Karolyi (2006) took a new look at the exposure puzzle by studying the potential impact of the introduction of the Euro on stock returns of 3,220 non-financial firms from 20 countries. Their findings suggest that the introduction of the Euro decreased foreign exchange rate exposure, but these changes are statistically and economically small.

According to Tesar and Dominguez (2006), factors such as firm size, multinational status, foreign sales, international assets, and competitiveness and trade at the industry level may influence economic exposure of the companies. These factors may either increase the companies’ economic exposure or decrease. These factors’ influence on the companies’ economic exposure will depend on how significantly these factors are correlated with the companies’ cash flows and operations, and if there are significant correlation between them, we should also point out whether these significant correlations are positive or negative.

Empirical analysis by Grambovas and McLeay (2006) confirmed that exchange rate fluctuations will affect firm values, especially with regard to the influence of exchange rate movements on the cash flows and accounting earnings of companies with international exposure, and on their stock prices.

Recent studies by Priestley and Odegaard (2007) studied the exchange rate exposures by orthogonalizing the market returns with respect to changes in exchange rates and a set of macroeconomic factors. Their findings suggest that the extent of exposures is only fully exposed when it is subdivided the sample period into regimes and at the same time used an orthogonalized market portfolio in the regression. Batram and Karolyi (2006) studied the exposure puzzle by looking at the potential impact of the introduction of the Euro on stock returns of 3,220 non-financial firms from different 20 countries. It was found that the introduction of the Euro had decreased foreign exchange rate exposure, but the changes were statistically and economically very small. However, Bae, Kwon, and Li (2008) having studied the exchange rate exposure and risk premium by using data on American depositary receipts (ADR) of Australia, France, Japan and the U.K., found that changes in the exchange rates were negatively correlated with the underlying shares of ADRs, but they were positively correlated to ADR returns observed in the U.S. markets. Moreover, they discovered that U.S. and local investors require different risk premiums for exchange rate risks presented in ADR investments.

Griffin and Stulz (2001) found weak evidence of statistically significant exchange rate exposures, and the economic significance of the estimated exposures was low. A first main study of the foreign exchange exposure fact done by Jorion (1990) found a significant impact of foreign exchange rate risk on share prices for 5.2 percent of the analyzed 287 U.S. MNCs at the 5 percent level. In their study, Choi and Prasad (1995) found that 14.9 percent of the individual firms in the U.S. and 10 percent of the industry portfolios showed a significant exchange rate exposure at the 10 percent level, corroborating earlier findings.

Comparable results were found outside the United States by He and Ng (1998). For instance only some multinational companies in Japan (26.3% and 53.8% for different time periods) showed a significant exchange rate exposure with regard to a multilateral exchange rate index. Some studies look into the exposure of industry portfolios in several countries, there were found percentage yields of companies with significant exposure of 15% (United States), 4% (Japan) and 6% (United Kingdom) by Prasad and Rajan (1995), or 23% (United States), 21% (Canada) and 25% (Japan) by Bodnar and Gentry (1993) at the 5% level. Study by Bartram and Karolyi (2006) suggests that the FX rate exposure of non-financial firms is systematically linked to firm characteristics such as sales, the percentage of foreign sales in general and in Europe in particular, regional factors like geography, strength of currency and industry characteristics like competition, traded goods. Study examined by Allayannis and Ihrig (2001) speak about stock price exposure to international trade activities of U.S. industries, and Bodnar et al. (2002) mention the significance of pass-through for exposure. Moreover, Starks and Wei (2004) found that the scale of exchange rate exposure is linked to proxies for probabilities of financial distress, product uniqueness and growth opportunities.

However, the evidence of corporate foreign exchange rate exposures on a cash flow basis is very thin and inadequate to individual case studies. Garner and Shapiro (1984) investigated the foreign exchange rate exposure of Vulcan Materials Company by regressing changes of its quarterly operating cash flows on changes in the exchange rate of USD against GBP, and showed only small and statistically irrelevant foreign exchange rate exposures. Moreover, Oxelheim and Wihlborg (1995) use quarterly changes of total cash flow, commercial cash flow and sales revenue as dependent variables in the exposure analysis of Volvo Cars. Results by Oxelheim and Wihlborg (1995) indicate that the financial situation of the company reduces exposures with regard to changes in the DEM/SEK exchange rate only to a modest degree. One more study by Bartram (2005) investigated the exposure of a large nonfinancial company based on proprietary internal as well as external capital markets data. Analysis by Bartram (2005) illustrated that the irrelevance of foreign exchange rate exposures of wide-ranging performance measures such as total cash flow and/or share price can be explained by hedging at the company level.