A Simple Model of Foreign Exchange Exposure

Abstract

The foreign exchange rate exposure of a firm is a measure of the sensitivity of its cash flows to changes in exchange rates. Since cash flows are difficult to measure, most researchers have examined exposure by studying how the firm’s market value, the present value of its expected cash flows, responds to changes in exchange rates. Empirical studies of the foreign exchange rate exposure of U.S. firms (for example, Jorion (1990), Bodnar and Gentry (1993), Amihud (1994), Choi and Prasard (1995), Griffin and Stulz (1997), and Allayannis (1997)), typically find low or negligible levels of exposure for most firms, even when the firms examined have significant foreign operations. This has been considered somewhat of a puzzle. None of these studies are based explicitly on a model of firm behavior, however, so it is difficult to interpret their findings of low exposure in terms of economic behavior.¹

Bodnar, Dumas, and Marston (1999) provide an explicit theoretical model and they find relatively high levels of exposure. But their model is estimated for a group of Japanese firms that have been chosen because they are likely to have high levels of exposure, since their purpose is to investigate the link between pass-through and exposure behavior in firms that have high levels of exposure. Other theoretical studies of exposure include Adler and Dumas (1984), Hekman (1985), Shapiro (1975), Flood and Lessard (1986), von Ungern-Sternberg and von Weizsacker (1990), Levi (1994) and Marston (2001). None of these studies have attempted to provide empirical estimates of their models.