Firm foreign activity and exchange rate risk

Abstract

Globally focused firms are the drivers of foreign exchange rate (FX) risk. Among the risk of the G10 currencies, the comovements with the largest currencies are the most important of the postulated risk factors. Firms’ exposure to FX risk is time-varying, is larger with respect to the home currency, and responds to fluctuations in the home FX. Firms are more sensitive to the currency risk of their geographical region, in line with a gravity effect, are more exposed in countries with a large export sector and when located in the peripheries of the global trade network. The extent of firms’ foreign activity most strongly matters in explaining their FX risk exposure, controlling for other firm-level characteristics such as size, leverage, and liquidity. Overall, our results point to the importance of the trade channel over the investment channel for FX risk pricing. Valuation Insight: Valuation of firms with substantial foreign trade depends importantly on exchange rate movements and exchange risk. This paper finds that such firms are more exposed to exchange risk when they are in countries with a large export sector and in countries on the periphery of the global trade network. Typically, such firms would have higher cost of equity capital which would affect value negatively. However, the paper finds that the exchange risk premia may be negative so that higher exchange risk exposure in fact lowers the cost of equity capital and enhances value.