Case Study of Exchange Rate Movements Onnon

8/18/2019 Case Study of Exchange Rate Movements Onnon

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The effects of exchange rate movements onnon-financial UK

firms


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Abstract

This study examines the effects of direct and indirect economic currency exposure on a group

of publicly-listed, non-financial UK firms. Information was obtained from the companies at

two points in time, during a period of sterling depreciation and then one of appreciation, and

the results compared. hen sterling depreciated, firms experienced increased profit mar-gins

and!or sales volumes and increases in the cost of foreign-sourced inputs. The opposite

conditions were reported for sterling appreciation. "ur results show considerable stability in

the estimates of economic exposure between the two periods. In managing currency effects,

about #$ per cent of exporting firms ad%usted either margins or volumes, or both, in response

to changes in the exchange rate. &s with other studies, we found a significant industry effect.

"verall we find that the results confirm the impact of economic currency exposure but, at thesame time, firms are less exposed to exchange rate movements than the theory would

suggest..

Introduction

The economic exposure model, as developed by 'uffy ()*#+, hapiro ()*#$,&dler and

'umas ()*/, 0lood and 1essard ()*2, oenen and 3adura ()**) and others, considers

the impact of exchange rate movements on firm value. 0irms engaging in foreign trade will

face timing effects in the payments and receipts of foreign currencies leading to transaction

exposure. &dditionally, firms with foreign operations also face translation exposure when

these are consolidated and notionally con-verted into the parent company4s currency.

5conomic currency exposure is a broader concept that includes both transaction and

translation exposure effects but also ta6es account of changes in the relative competitive

position of firms resulting from unanticipated currency movement (7ringle, )**)8 hapiro,

)**+. The theory emphasises that it is the nature of the competitive environment in which

the firm operates and the type of products involved that determine firms4 sensitivity to

exchange rate move-ments. 1uehrman ()**9 argues that exposure depends on demand shifts

and how competitors react to currency movements. :odder ()*+ points out that even those

firms with a purely domestic cost and revenue base but with foreign-domiciled com-petitors

will be affected. o absence of foreign currency transactions does not auto-matically

eliminate economic exposure. In addition, these domestic-only firms maybe indirectly

affected by currency effects due to their suppliers sourcing abroad. 0lood and 1essard4s

()*2 model for economic exposure ta6es into account both costs and revenues. They


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postulate that multinational corporations that both source and sell in competitive international

mar6ets will be less sensitive to changes in foreign exchange rates than those firms engaged

solely in importing or exporting .7ringle and ;onnolly ()** ?lac6, )**+.@esearch in this

area has focused on the competitive situation of the firm and how unexpected movements in

exchange rates affect the value of the firm. 3ost large-scale studies have used mar6et-based

variables, regressing the change in share price against movements in an exchange rate or a

trade-weighted index, to obtain a meas-ure of the sensitivity of firm value to currency

movements (&mihud, )**/8 ?artov, ?odnar > Kaul, )**28 ?odnar > Aentry, )**


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movements in the three specific areasE the effects of sterling appreciation and depreciation,

firms4 exchange rate sensitivities and the nature of the trade-off between sales volumes and

profitability, and finally, industry effects.

Effects of exchange rate movements

If economic exposures are symmetrical, we can expect to see opposing results from periods

of sterling appreciation and depreciation on corporate cash =ows and profitability. 0irms that

are disadvantaged in periods of sterling depreciation, i.e. Importer firms with more costs

denominated in foreign currencies than revenues, will benefit from currency appreciation. e

first examine the impact on firms from the directional movements in the exchange rate before

examining firms4 sensitivity and hence exposure to currency movements. In particular, we

wanted to test the hypothesis that indirect economic exposure effects were an important

element of exposure. 0inally, we also examine firms by industry sector to determine whether

there are significant differences in economic exposure that re=ect firms4 mar6et positioning

our research instrument, we ma6e use of three economic exposure effects on firms. 0irst, the

direct currency effect of reduced export revenues and increased import costs, although the

immediate impact may be deferred due to earlier currency hedging. econd, the indirect

effect of the improved relative position of competitors in countries with wea6er currencies,

thus enabling them to discount prices in the mar6et. The opposite effect applies to

competitors in countries with stronger currencies. Third, the indirect effect from the firm4s

exposed customers and suppliers to similar price pressures. 0inally, we examine industry

effects. "n the whole we find that our sample has less economic exposure than predicted by

the theoretical models and that significant industry differences exist.

Appreciation and depreciation of sterling

& change in the external value of sterling either decreases (in the case of appreciation or

increases (in the case of depreciation the amount of home currency UK ;ompany receives

for a unit of foreign currency. &s hypothesised by al6er ()*2, this affects the cash =ows

of ?ritish companies that source inputs or sell their products abroad as a result of changes in

foreign demand and profit margins. 0or firms with significant foreign sales (i.e. exporters,

sterling depreciation should raise sales volumes and!or increase margins whereas those firms

with significant foreign inputs (that is, importers should experience reduced sales volumes

and!or profit margins. &n appreciation in sterling should have the opposite effects.


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Industry effects

3offet and Karlsen4s ()**/ model proposes that economic currency exposure Isa function of

the competitive environment. ?odnar and Aentry ()**


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sensitive to changes in sterling, but this then forces them to absorb exchange rate =uctuations

via their profit margins.

Conclusions

This paper ma6es use of survey data to determine the degree to which non-financial UK firms

are exposed to currency effects, as well as examining specific contributory factors discussed

within the literature. The advantages of the approach are that it enables a representative cross-

section of firms to be included in the data set and a range of replies can be generated. The

wea6nesses, as the case study illustrated, are that the estimates are aggregates of specific line

of business, or even product, sensitivities and hence are imprecise. @espondents were also presented with a set of alternatives that may be difficult to relate to their specific situation.

Bevertheless, within these limitations, the survey method does permit us to explore the

important interactions between firms4 behaviour and changes in the exchange rate. &ccording

to the theory of economic exposure, movements in exchange rates can affect the future cash

=ows of almost all types of firms whether involved directly in cross-border transactions or

not. ithin the limitations of our methodology, our findings for UK companies provide

empirical support for the positive and negative effects of economic currency exposure. The

results indicate that the direct impact of exchange rate movements affects firms4 sales

volumes or profit margins, or both, and input costs. The findings are also consistent with the

notion that exchange rate movements lead to the indirect, competitive effects as proposed in

the hapiro ()**+ and 7ringle and ;onnolly ()**


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exchange rate sensitivity of sales volumes, profit margins and costs, more than half the

respondents ran6ed these as being insensitive, that is, either G)4 or G+4. This is surprising in

that only )$ per cent of the responding companies can be regarded as purely domestic in the

sense that they do not source or sell in foreign mar6ets. There exists, however, a small

proportion of respondents who indicated that cash =ows were highly sensitive to exchange

rates . "ur case studies also revealed some of the complexities in pro-voiding a taxonomy of

economic exposure. These emphasised the importance of firms 4strategies, pricing policies

and product mix as contributors. This suggests that future research needs to examine these

factors through more sophisticated evaluation techniDues in order to identify firms with high

and low levels of economic exposure. 0urther wor6 using the case study methodology

suggests one potential avenue. There is also scope for combining our survey methodology

with econometric techniDues, such as that of Corion ()**9, 'onnelly and heehy ()**2, and

3iller and @euer()**.0inally, how can the low sensitivities found in our research be

reconciled with the theory of economic exposure which suggests that changes in exchange

rates directly or indirectly affect the cash =ows of most firmsH "ne explanation is that many

of these Duoted firms are, in effect, multinational corporations with both sales and costs

arising in foreign currencies.

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Case Study of Exchange Rate Movements Onnon