Exchange rate exposure, competitiveness and firm valuation: Evidence from the world automotive industry

Financial theory predicts that a change in the real exchange rate should affect the value of a multinational firm. Surprisingly, past research has not supported this theory, even after considering the substantial exchange rate volatility over the past 23 years. This study develops and tests the predictions of a model of the effect of a real exchange rate change on the value of a multinational firm. The model and tests assume global market efficiency and that finns exhibit net exchange rate exposure. One of the main implications of the model is that not only does the exchange rate exposure depend on the foreign sales of a multinational firm but also on the demand and supply elasticities for the firm's products.; The analysis is done at the country-specific portfolio and firm level using a sample of automotive firms from the US, Japan and Germany. Consistent with model predictions, I find significant exchange rate exposure of these firms to exchange rate shocks. The results also show that the industry's competitiveness is a key determinant of the exposure level and there is cross-country wealth redistribution resulting from a change in real exchange rates. Furthermore, there is evidence of time variation at both the country specific portfolio and firm level which is consistent with changes in the industry's competitiveness. F-tests of cross sectional variation in the exchange rate exposure of these firms are consistent with a prediction of significant differences in exposure across firms. Using monthly sales information, an analysis of the components to the country specific portfolio exposures is done. The results show that the components of exposure varies across firms from the each market due to the firm's market share and that of its foreign competitors. Also, evidence of a significant lagged component to exchange rate exposure, as measured by the stock price, implies that there is mispricing of the exchange rate to firm value relation by the market.; Finally, a real options approach is used to argue the existence of a nonlinear component to exchange rate exposure. This approach is based on the idea that there is some hedging value to a firm that has the option to switch production between markets. The model leads to a prediction that there is a band of exchange rates in which the firm can switch production between markets at a nominal cost and thus has negligible exchange rate exposure within this band. Consequently, non-linearity results from the measurable exposures outside this band and immeasurable exposure within the band. Therefore, the exchange rate level as well as the changes in the exchange rate are necessary in evaluating a firm's exposure. Consistent with the real options approach and asymmetric hedging, some firms exhibit evidence of a nonlinear component to their exchange rate exposure. The value of the switching option is greater for those firms with significant foreign production capacity.