Journal of International Money and Finance

19 (2000) 117–134
www.elsevier.nl/locate/econbase

Exchange rate movements and the profitability

of U.S. multinationals
*
Ting Gao
Department of Economics, University of Missouri, 118 Professional Building, Columbia, MO 65211,
USA

Abstract

This paper studies the effects of unexpected exchange rate movements on the stock returns
of U.S. multinationals. Unlike most previous studies of exchange rate exposure, we explicitly
consider the time variability of exchange rate exposure by taking into account firms’ foreign
sales and foreign production information in our tests. Empirical results based on a sample of
eighty U.S. multinationals from seven 3-digit SIC manufacturing industries show that the stock
market correctly reveals the profitability effects of exchange rate news predicted by theory.
A depreciation shock to the U.S. dollar, for example, has significant positive effects on the
abnormal returns on the stocks of the multinationals through foreign sales and significant
negative effects through foreign production.  2000 Elsevier Science Ltd. All rights reserved.

JEL classification: F23; F31; G15

Keywords: Exchange Rate Exposure; Multinationals

1. Introduction

Empirical studies of foreign exchange exposure mostly fail to detect a significant

link between exchange rate movements and contemporaneous changes in the value
of a multinational firm (see, for example, Jorion, 1990; Amihud, 1994; Bodnar and
Gentry, 1993). This is inconsistent with the common belief that exchange rate fluc-
tuations change the domestic currency revenues and costs of a multinational with
foreign sales and operations, and therefore affect the value of the firm. One possible

* Corresponding author. Tel.: +573-884-8004; fax: +573-882-2697.

E-mail address: gao@missouri.edu (T. Gao)

0261-5606/00/$ - see front matter  2000 Elsevier Science Ltd. All rights reserved.
PII: S 0 2 6 1 - 5 6 0 6 ( 9 9 ) 0 0 0 3 8 - 8
118 T. Gao / Journal of International Money and Finance 19 (2000) 117–134

explanation is that the conventionally defined exchange rate exposure simply is time
varying (Levi, 1994). The time variability of exchange rate exposure is partially
confirmed in several previous studies in the literature (Amihud, 1994; Jorion, 1990).
This paper is yet another effort to provide empirical evidence on the sensitivity
of the value of multinational firms to exchange rate news by exploiting firm-level
data. Unlike most previous studies, this study focuses on two major channels through
which exchange rate news influences profitability: foreign sales and foreign pro-
duction. Conceptually, even a firm with few international operations may be subject
to exchange rate risk indirectly. The extent to which a firm exposes itself to exchange
rate risk depends on many aspects of the firm. But there is no doubt that a multina-
tional’s foreign production and sales are two important determinants of its exchange
rate exposure because exchange rate fluctuations directly impact the revenues and
production costs of the firm through these two channels.
Taking into account information on firms’ foreign sales and production over time
allows us to address at least partially the time-variability problem, and may shed
some light on why previous research has been unsuccessful in documenting signifi-
cant relations between changes in the exchange rate and the value of a multinational.
Without being comprehensive, this study focuses only on manufacturing multination-
als with relatively large volumes of foreign operations. These firms seem to be more
vulnerable to foreign exchange rate shocks, and are often the subject of research in
the literature.
There are at least two apparent difficulties with this task. Firm-level data useful
for our purpose are scarce, and other determinants of exchange rate exposure are
complex and sometimes unclear. For example, no micro data are available to
researchers about the details of how a firm hedges against exchange rate fluctuations.
A firm may be able to reduce its exchange rate exposure by carefully designing its
financial market strategy, as an increasing number of financial instruments are avail-
able. Without this information, however, it is not clear to what extent these hedging
activities may change the measure of the profitability effect of the exchange rate.
As a result, all the estimates presented in this paper should be regarded as after-
hedge measures. The purpose of this paper is then to investigate the important sources
of remaining exchange rate risk by extracting as much useful information as possible
from available data.
The rest of the paper is organized as follows. Section 2 is a brief review of recent
studies that are closely related to this research. Section 3 derives an econometric
specification to examine the sensitivity of profitability to exchange rate news. Data
preparation and econometric methodology are discussed in Section 4. Estimation
results along with discussions and comments are presented in Section 5. Section 6
concludes the paper.

2. Literature

An often-cited, early theoretical treatment of this issue is in Shapiro (1975). In a

partial equilibrium model, this study looks at the change in the value of a multi-
 T. Gao / Journal of International Money and Finance 19 (2000) 117–134 119

national corporation caused by an exchange rate or inflation shock. It is concluded

that exporting firms gain in profitability from a depreciation of the domestic currency,
which is consistent with the conventional wisdom.
The empirical tests in Gardner (1986) are similar in design to those performed in
the present study. Gardner examines the impact of the exchange rate on the stock
market performance of several companies in the instruments industry. In his study,
some macroeconomic considerations are incorporated into the standard capital asset
pricing model to investigate how these companies’ stock market returns respond to
exchange rate changes. He concludes that the effect of the exchange rate is small
and statistically insignificant.
However, Gardner’s study is limited by the use of a small data set of only eight
firms in a single industry and the treatment of some variables due to the unavailability
of firm-specific information at the time the study was conducted.1 The study
presented here can be viewed as an extension of Gardner’s work, with the basic
elements in the econometric model being borrowed from his. However, considerable
modifications are made, both in the empirical model and the specification of
exchange rate dynamics. Some detailed firm-level information makes this empirical
study more rigorous. An alternative specification is also estimated as a sensitivity
check. The scope of this study is also much broader, with eighty U.S. multinational
corporations from seven 3-digit SIC industries included in the sample.
Grossman and Levinsohn (1989) study import competition and the stock market
return to capital. Though their emphasis is on the sensitivity of the stock market
return to import price news, the empirical specification also includes foreign
exchange rate news as an independent variable in explaining the excess stock market
returns of firms in six U.S. import-competing industries. A byproduct of their
research is the insignificance of exchange rate news in all the industries.
In the international business and finance literature, there has been a fair amount
of research on exchange rate exposure.2 To summarize, the exchange rate exposure
of firm i, gi, is defined as the correlation between the firm’s stock market returns
and the changes in the exchange rate, conditioning on the average stock market rate
of return. The usual estimation specification takes the form of Eq. (1)
rit⫽ai⫹birmt⫹gi⌬et⫹⑀it (1)
where rit is the stock market return of firm i over period t, rmt is the market portfolio
rate of return, and ⌬et, is the change in the logarithm of the exchange rate. Recent
empirical work using this approach includes Jorion (1990), Khoo (1994), Bodnar
and Gentry (1993) and Amihud (1994).3 These studies tend to show that gi is small

1
In Gardner (1986), foreign sales and production for each firm are treated as fixed over the entire
sample period: 1978–1985.
2
The formal definition of exchange rate exposure in this literature can be found in Adler and
Dumas (1984).
3
Jorion (1990) studies exchange rate exposure using a sample of 287 U.S. multinationals; Khoo (1994)
examines mining companies in Australia; Bodnar and Gentry (1993) relate the exposure measure to indus-
try characteristics for a sample of Canadian, Japanese and U.S. companies; Amihud (1994) studies the
top fifty U.S. exporters listed by Fortune magazine.
120 T. Gao / Journal of International Money and Finance 19 (2000) 117–134

and statistically insignificant, even for large exporting firms with a lot of foreign
operations.
There are two possible reasons for the insignificance of gi. First, as pointed out
by Levi, gi varies over time. Second, the exchange rate affects the profitability of a
firm through many channels. Effects through different channels may be offsetting to
one another, and gi captures only the overall exchange rate effect. In light of these
concerns, this study goes beyond the simple measure of exchange rate exposure,
investigating two important channels that may contribute to the time instability of
ri as well as to the offsetting effects: the allocations of a firm’s sales and production.
In this paper, we take into account firm-level information on foreign sales and foreign
production over time, and directly estimate the effects of exchange rate news on
stock returns through foreign sales and production. Therefore, compared to the pre-
vious studies on exchange rate exposure, this study has a more detailed implemen-
tation.

3. Econometric specifications
3.1. The model
The starting point of our empirical investigation is a simple market model,
rit⫺rft⫽bi(rmt⫺rft)⫹⑀it, (2)
where i is the firm index, rft is the risk-free rate of return in period t, and rit and rmt
are defined in the same way as in Eq. (1).
If the firm faces idiosyncratic foreign exchange rate risk for any reason, provided
the exchange rate is correctly interpreted, the effects of exchange rate news on the
firm’s stock return will be captured in ⑀it. In the efficient stock market, if there is a
shock that alters a firm’s expected future cash flows, forward-looking investors will
immediately revise their pricing of the firm’s security, taking into account the effects
of such a shock. Only unanticipated changes will affect the current abnormal return,
with anticipated changes being taken into account earlier when they were perceived
by investors.
Let deut be an unanticipated exchange rate change. Then it should be part of ⑀it.
Eq. (2) thus can be rewritten as follows
rit⫺rft⫽bi(rmt⫺rft)⫹gideut⫹mit, (3)
where gideut+mit=⑀it and gi measures the degree to which exchange rate news contrib-
utes to the abnormal return. In fact, Eq. (3) is very similar to Eq. (1).
To construct exchange rate news deut, exchange rate dynamics need to be specified.
Due to implementational difficulties, the “pure” macro models of exchange rate
dynamics are avoided.4 Instead, two alternative processes are proposed. The first

4
The literature on international macroeconomics provides several models of exchange rate dynamics,
each with its own ad hoc assumptions and limited empirical support. See Meese and Rogoff (1983) for
empirical predictability of some macro and statistical models of the exchange rate. The following equation
is a general specification of macroeconomic exchange rate dynamics which includes the essential elements
 T. Gao / Journal of International Money and Finance 19 (2000) 117–134 121

choice is a statistical one. If a long-run equilibrium exchange rate e* exists, a reason-

able approximation of the actual exchange rate behavior is the following first-order
autoregressive process
et+1⫽q1et⫹(1⫺q1)e∗⫹deut,
or
et+1⫽q0⫹q1et⫹deut (4)
If q1 is equal to unity, Eq. (4) becomes a random walk process.
To recognize the significance of some macro variables in predicting movements
of the exchange rate, an alternative is proposed as follows:

冘 冘 冘 冘 冘
n1 n2 n3 n4 n5

⌬et⫽q0⫹ aR,j Rt−j ⫹ am,j mt−j ⫹ ay,j yt−j ⫹ aTB,j TBt−j ⫹ ap,j pt−j (5)
j⫽1 j⫽1 j⫽1 j⫽1 j⫽1

⫹deut,
where ⌬et=et⫺et⫺1, Rt is the interest rate, mt is the money supply, yt is industrial
production, TBt is net exports, and pt is the rate of inflation. All these are domestic
variables. How many lags of Rt, mt, yt, TBt and pt to be used in estimation will be
determined later. The residual term, deut, then is the unanticipated change in the
exchange rate.5
Note that even the unanticipated part of an exchange rate movement does not
necessarily evolve exogenously. Some unobservable nominal or real aggregate
shocks may affect both the stock market return and the exchange rate. The endogen-
eity of exchange rate news may bring bias and inconsistency in estimation. To see
what problems the endogeneity may cause, let us suppose that there is a shock in
mit that affects both the firm’s abnormal return rit⫺Et⫺1rit and the exchange rate et.
If this shock is not controlled in the construction of exchange rate news, then deut
is correlated with mit. The estimate of gi from Eq. (3) will be biased and inconsistent.
The unanticipated change in the exchange rate, deut, in Eq. (5) by construction is
orthogonal to the macro variables included in the equation as explanatory variables.
This should reduce the degree of endogeneity. Both exchange rate processes, Eqs.
(5) and (4), will be used in estimation to check the sensitivity of the empirical results
with respect to the specification of exchange rate dynamics.

in various macro models.

et⫽a0⫹a1(m⫺m∗)⫹a2(y⫺y∗)⫹a3(rs⫺r∗s )⫺a4(pe⫺p∗e)⫹a5TB⫹a6TB∗⫹u,
where m⫺m* is the logarithm of the ratio of US. money supply to foreign money supply, y⫺y* is the
logarithm of the ratio of U.S. income to foreign income, rs⫺r∗s is the short-term interest rate differential,
and pe⫺p*e is the expected long-term inflation differential. TB and TB∗ represent the cumulative U.S.
and foreign trade balances. The difficulty of applying this to our context is the aggregation of foreign
variables, since the exchange rate to be used is a trade-weighted average rather than bilateral ones.
5
One might suggest that foreign variables be included in Eq. (5). Due to the difficulty of dealing with
the aggregation of foreign country variables, they are omitted.
122 T. Gao / Journal of International Money and Finance 19 (2000) 117–134

In principle, Eq. (4) or Eq. (5) can be combined with Eq. (3) to estimate the
coefficient gi, which is essentially the coefficient to be investigated — the sensitivity
of the stock market return of firm i to exchange rate news. But we go a step further
with the following concern. gi measures the overall effect of exchange rate news on
the abnormal stock return. Over time, a firm increases or reduces its foreign sales
and makes adjustments in its foreign production, and therefore the coefficient may
not be stable over time. As a result, the estimate will have no clear economic mean-
ing. With detailed information on firms’ foreign operations, gi can be decomposed
in a sensible way.
Since the sales and production allocations of a multinational firm have been fre-
quently singled out as two important determinants of exchange rate exposure, we
express gi as a linear function of the share of foreign sales in the firm’s total sales,
sit, and the share of foreign output in the firm’s total output, xit:
gi⫽fi1sit⫹fi2xit⫹fi3. (6)
The parameters fi1, fi2 and fi3 are treated as constants. Both sit and xit change over
time, so the decomposition allows ri to be time varying.
Theory predicts that in general fi1 is positive and fi2 is negative.6 Everything else
being equal, an unanticipated depreciation of the U.S. dollar increases a firm’s rev-
enues from foreign sales in dollar terms and therefore increases its profit through a
translation effect, hence a positive shock to the profitability of the firm. This is
reflected in a positive fi1. The interpretation of the sign of fi2 is somewhat trickier.
The sign depends on the weight of inputs into the firm’s foreign production that are
purchased in foreign currency. A depreciation of the dollar leads to higher costs of
production carried out abroad in dollar terms if more inputs in the firm’s foreign
production are purchased in foreign currency. It is also through a translation effect,
but on the cost side. Under fairly general conditions, this effect on profitability is
expected to be negative.
Of course, the discussion above is oversimplified. Conceivably, also relevant are
other things such as the elasticity of price with respect to the exchange rate, foreign
content in domestic production, the demand elasticity for imported inputs with
respect to the exchange rate, etc. Since these are not observable, they are either
incorporated in fi1 and fi2, or being picked up by the residual term fi3, whose sign
is therefore unpredictable. Jorion (1990) examines cross-sectionally the relationship
between the exposure measure gi of individual firms and their foreign involvement,
and finds that gi is positively associated with the ratio of foreign to total sales. The
evidence is consistent with our interpretation of the sign of fi1 above.
Also note that market structure matters in determining exchange rate exposure
because exchange rate movements can lead to strategic reactions of imperfectly com-
petitive firms and therefore changes in profitability. This consideration can substan-
tially complicate the profitability effects of the exchange rate. Marston (1996) pro-

6
It would be easier to see this if one writes down the expression of a multinational’s profit in terms
of sit and xit. A previous version of this paper has a lengthy treatment of this, and is available upon request.
 T. Gao / Journal of International Money and Finance 19 (2000) 117–134 123

vides a detailed theoretical treatment of the effects of industry structure on economic

exposure. To avoid possible complications resulting from imperfect competition, we
choose a sample of multinational firms operating in a relatively competitive environ-
ment in the empirical study.
Combining Eqs. (3) and (6) gives us the following relation:
rit⫺rft⫽bi(rmt⫺rft)⫹(fi1sit⫹fi2xit⫹fi3)deut⫹mit. (7)

The complete econometric model consists of two equations: Eq. (7) that relates
the stock return of a multinational firm to exchange rate news, and Eq. (5) that
specifies exchange rate dynamics. The focus of our empirical investigations is on
the signs and magnitude of the estimates of fi1, fi2 and fi3. In some of the estimations,
exchange rate news constructed from Eq. (4) is also used as a sensitivity check.

3.2. An alternative specification

Grossman and Levinsohn (1989), in their investigation of the impact of import

competition on the stock market return to capital, propose a multi-factor econometric
model to estimate the determinants of the abnormal stock return. The idea can be
traced back to Pakes (1985). Pakes studies the relationship among the number of
successful patent applications of industrial firms, R&D expenditure, and the stock
market value of the firm as an indicator of the inventive output. In determining the
value of the firm in the stock market, forward-looking investors efficiently use all
available information on the change of future cash flows caused by the inventive
input. Similarly we assume that the stock market is efficient in such a way that
abnormal stock market returns are caused only by unexpected changes in the determi-
nants of the stock price.
The excess stock return of firm i is expressed as
rit⫺Et−1rit⫽ki(zit⫺Et−1zit), (8)
7
where zit is a vector of variables that help predict the value of the firm.
Eq. (8) takes into account the forward-looking behavior of investors in evaluating
the firm’s value. Only news in zit will affect the current abnormal stock return. If
exchange rate news helps explain the abnormal return to the firm, it must be one of
the elements in zit.
To separate out the effect of exchange rate news, we make use of the discussion
in Section 3.1 and rewrite Eq. (8) in the following way
rit⫺Et−1rit⫽ki(z1it⫺Et−1z1it)⫹(fi1sit⫹fi2xit⫹fi3)deut⫹⑀it, (9)
1
where z consists of all variables in zit except deut.
it
It is necessary to replace the expected individual stock return Et⫺1rit, since it is

7
Grossman and Levinsohn (1989) derive this expression from the decision of maximizing the value
of a firm.
124 T. Gao / Journal of International Money and Finance 19 (2000) 117–134

not observable. In their paper, Grossman and Levinsohn make the assumption of
risk neutrality so that the expected market portfolio return is equal to the expected
individual stock return. However, risk neutrality seems to be an unrealistic way to
describe the behavior of investors.
Here we take a different approach by assuming that the expected stock market
return on firm i is the risk free rate plus a firm-specific risk premium.8
Et−1rit⫽rf⫹ci. (10)

Combining Eqs. (9) and (10) yields

rit⫺rf⫽ci⫹ki(z1it⫺Et−1z1it)⫹(fi1sit⫹fi2xit⫹fi3)deut⫹mit. (11)

The following aggregate and industry-specific variables are chosen to be the

elements of zit: the unemployment rate, a producer price index, the money supply
(M1), an energy price index, a nonagricultural wages index, an industry-specific
wage index, and an industry-specific export-weighted exchange rate. These variables
are a subset of the variables used in Grossman and Levinsohn (1989). Two variables
on their list, an industry-specific import price index and an aggregate import price
index, are dropped here since the industries studied here are not import-competing
industries and these variables should not be important. The news in the chosen vari-
ables will be constructed, and the following equation will be estimated
rit⫺rf⫽ci⫹pi1UNEMNEWS⫹pi2PPNEWS⫹pi3MNEWS⫹pi4ENNEWS (12)
⫹pi5AGGWNEWS⫹pi6WNEWS⫹(fi1sit⫹fi2xit⫹fi3)deut⫹mit.
where the news variables in Eq. (12) are explained in Table 1. Eqs. (12) and (5) are
the alternative model to be used in our empirical studies.

Table 1
News variables

Variable Description

UNEMNEWS The News to the Unemployment Rate

PPNEWS The News to a Producers Price Index
MNEWS The News to the Money Supply (M1)
ENNEWS The News to an Energy Price Index
AGGWNEWS The News to an Aggregate Wage Index
WNEWS The News to an Industry-Specific Wage Index

8
Merton (1980) proposes three approaches to estimate expected returns on the market portfolio or
individual stocks. This is the one Merton calls the “state-of-the-art” approach since it comes naturally
from some popular asset pricing models at that time. The other two methods relate the risk premium to
the variance of stock returns so that ci is no longer a constant. No attempt is made in his paper to evaluate
which approach yields better estimates.
 T. Gao / Journal of International Money and Finance 19 (2000) 117–134 125

4. Data and econometric methodology

4.1. Data

The models derived in Sections 3.1 and 3.2 apply to any manufacturing multi-
national firm as long as the required data are available. But including all such firms
in the study appears to be impossible, due to the huge amount of data work involving
searching and matching the useful information from each company’s corporate
reports. To take a shortcut to identify multinational firms for our empirical studies,
we go through the following steps.
First, a list of 3-digit SIC industries is selected by looking for high ratios of trade
to domestic output in the U.S. Commodity Exports and Imports as Related to Output:
1990 and 1989 published by the U.S. Department of Commerce. Usually, multina-
tionals can be easily found in the industries with large trade volume. Note that these
industries should not necessarily be categorized as exporting industries since import
penetration ratios may be high as well. To avoid the complications market structure
can cause in interpreting the results, industries that appear to have a high degree of
market concentration are dropped.9
In the next step, a list of publicly held companies for each industry is obtained
from the Compact Disclosure and Disclosure/World Scope database with the compa-
nies’ primary product line coinciding with the industry SIC code. The Compact Dis-
closure is a collection of corporate annual reports of more than ten thousand U.S.
and foreign companies. The Disclosure/World Scope is a separate database for more
than ten thousand companies in the world.10 An individual company annual report
may include a foreign activities section, which provides information on foreign sales
and foreign assets of the company over the past six years (1988–1993). Only U.S.
companies with foreign sales and assets information available are included on the list.
In the last round of selection, the list of companies is checked with the CRSP
datafile. Only those traded in the New York Stock Exchange or American Stock
Exchange with a complete record of monthly stock returns over the period 1/1988–
9/1993 in the datafile are kept in the final sample.
Upon completion of the selection, seven manufacturing industries are on our final
list. Table 2 is a description of these industries. Their SIC codes are 267, 281, 283,
353, 367, 382 and 384. For each of them, there is a list of companies with complete
records of stock returns, foreign sales and foreign assets throughout the period 1988–
1993. Some descriptive statistics for the sample companies in those industries are
collected in Table 3.
Data for the econometric model, Eqs. (7) and (5), are from the following sources.
Monthly returns on individual stocks and the market portfolio are from the CRSP

9
The criterion we use, which is somewhat arbitrary, is that industries in which the three largest compa-
nies account for more than 70 percent of total industry sales, are dropped. The necessary information is
from Ward’s Business Directory of largest U.S. Companies.
10
Compact Disclosure is available on CD-ROM by Disclosure Incorporated. Disclosure/World Scope
is made available by Worldscope/Disclosure Partners (W/D).
126 T. Gao / Journal of International Money and Finance 19 (2000) 117–134

Table 2
3-Digit SIC industries in the samplea

3-digit SIC Description

Industry

267 Converted Paper and Paperboard Products, except Containers and Boxes
281 Industrial Inorganic Chemicals
283 Drugs
353 Construction, Mining, and Materials Handling Machinery and Equipment
367 Electronic Components and Accessories
382 Laboratory Apparatus and Analytical, Optical Measuring and Controlling Instruments
384 Surgical, Medical and Dental Instruments and Supplies

a
(Source: Standard Industries Classification (1987) Revision).

Table 3
Some statistics for the sample 3-digit SIC industriesa

Industry SIC Code 267 281 283 353 367 382 384

Exports/Output (1990) (percentage) 4.1 22.6 10.6 33.0 28.6 35.2 20.2
Imports/(Output+Imports) (1990) (percentage) 3.7 16.6 7.6 15.9 26.0 15.3 11.5
Number of Firms in the Sample 8 11 15 6 18 17 5
Sample Mean of the Ratio Foreign Sales/Total Sales 27.1 32.2 38.7 28.8 37.1 31.2 32.3
(1990) (percentage)
Sample Mean of the Ratio Foreign Assets/Total 28.1 29.8 29.7 28.2 31.3 28.1 33.6
Assets (1990) (percentage)

a
Note: Output is the Manufacturers’ shipments (f.o.b. plant).
Source: U.S. Commodity Exports and Imports as Related to Output: 1990 and 1989; Compact Disclos-
ure Database.

1993 masterfile. Monthly S&P500 stock index returns are used for the market port-
folio returns. The three-month treasury bill rates, converted from annual rates to
monthly returns, are taken from Citibase as the risk free rate and the interest rate in
the estimations. For each company, annual measures of percentage foreign sales and
foreign assets are obtained from the Compact Disclosure database. Exchange rates
between the dollar and foreign currencies are taken from the National Trade Data
Bank (NTDB), originally from the Board of Governors of The Federal Reserve Sys-
tem. For each industry, the exchange rate used in the estimations is a detrended log
export-weighted exchange rate. The weights are determined by industry-specific
export volumes to the major U.S. trading partners in 1990 reported in the U.S. Indus-
trial Outlook (1992) or the U.S. Exports by SIC industries compiled by the Bureau
of Census.
For the alternative specification in Section 3.2, monthly aggregate variables —
the unemployment rate, a producer price index, an energy price index, an aggregate
wage index, and industry-specific wage indexes are from Citibase.
 T. Gao / Journal of International Money and Finance 19 (2000) 117–134 127

4.2. Methodology and econometric concerns

With the data described above, let us first turn to the estimation of system, Eqs.
(7) and (5). The two equations can be combined into the following

冘 冘
n1 n2

rit⫺rft⫽bi(rmt⫺rft)⫹(fi1sit⫹fi2xit⫹fi3)(⌬et⫺q0⫺ aR,j Rt−j ⫺ am,j mt−j (13)

j⫽1 j⫽1

冘 冘 冘
n3 n4 n5

⫺ ay,j yt−j ⫺ aTB,j TBt−j ⫺ ap,j pt−j )⫹mit.

j⫽1 j⫽1 j⫽1

An OLS estimation of Eq. (13) will be presented in next section.

However, since Eq. (13) involves a decomposition of the disturbance term, the
one-step estimation may lead to biased and inconsistent estimates of the model para-
meters. Levinsohn and Mackie-Mason (1990) specifically raise this issue in the case
of a market model and propose a simple two-step estimation to correct the potential
inconsistency. Their two-stage estimation procedure, applied to our model, goes as
follows. In the first stage, Eq. (2) is estimated for each firm or industry (if one
assumes that firms within an industry have the same risk measure b, as we will).
Also Eq. (5) is estimated separately. The results of these estimations (estimated
residuals for deut and estimated b) are then used in the second stage to estimate Eq.
(7) as follows:
rit⫺rft⫺b̂i(rmt⫺rft)⫽(fi1sit⫹fi2xit⫹fi3)dêut⫹mit. (14)
As long as dêut is a consistent estimate of deut, this approach yields consistent esti-
mates of fi1, fi2 and fi3.
Ideally, the models of Eqs. (7) and (5) should be estimated for each firm. However,
information is not available on the destination of foreign sales or the foreign pro-
duction allocation for each firm, and there is no way to construct an appropriate
firm-specific exchange rate. Moreover, six-year period monthly observations for one
firm are quite limited. So we follow Grossman and Levinsohn (1989) in assuming
that all firms within one industry have the same broadly-defined technology and
capital structure, i.e. they have the same slope b. Under this assumption, observations
of these firms can be pooled together, and a data set for each industry with time-series
and cross-sectional variation can be constructed. Since industry-specific exports by
country are usually available, the export-weighted average exchange rate can be eas-
ily constructed. We can test the null hypothesis that b’s are the same across firms
within an industry by F-statistic. But such a test may not be powerful due to the
small sample size.
Panel data techniques are applied in the second stage of the estimation. For system
Eqs. (7) and (5), Eq. (7) is estimated by the random effects model.11 The structure
of the error term in Eq. (7) is assumed as follows

11
We also estimate Eq. (7) by the fixed effects model. The results are quite similar to those from the
random effects model, and therefore are not reported in this paper.
128 T. Gao / Journal of International Money and Finance 19 (2000) 117–134

mit⫽rt⫹nit,
where rt represents the time component of the error term applying to all firms, and
nit is an idiosyncratic random error.
For the alternative specification, Eqs. (12) and (5), exchange rate news is con-
structed in the same way. Since this specification serves as a sensitivity check, we
only report results from a two-stage estimation. To deal with the constant, ci, the
fixed effects model is chosen. The news to the other variables used in this estimation
(news variables are listed in Table 1) is constructed by estimating a fourth-order
autoregressive process of each of these variables.
Some concerns arise from the data and methodology outlined above. The two
share variables, sit and xit, are the focus of this study. But the exact foreign production
information xit is not publicly available. In fact, it may even be difficult to define
such a term practically since foreign production of multinationals in general is carried
out by their foreign affiliates. Instead, the measure of the share of foreign assets in
a company’s total assets can be found.
Foreign assets are the sum of foreign productive and other types of financial
assets. Here this measure is used as a proxy for xit. It would be a good approximation
if foreign asset holdings are mainly in the form of productive assets. Unfortunately,
the corporate reports provide no information in this regard. Moreover, monthly data
are used to estimate system Eqs. (7) and (5), but the information on sit and xit is
available annually. To deal with this, the shares of foreign sales and foreign pro-
duction are simply treated as fixed within each year. For most of the firms, those
variables are fairly stable, and such a treatment should not bias the results signifi-
cantly.
A question concerning the consistency of the variance-covariance matrix in the
two-stage estimation is discussed in Grossman and Levinsohn (1989). When the
residuals from the first stage estimation are used as explanatory variables, and the
corresponding predicted values themselves are not included in the regression, the
calculated standard errors will be consistent estimates of the true standard errors.
But this is not the case when the dependent variable is an estimated residual, Since
the sample correlation between the market return rmt and exchange rate news deut is
very small, the bias in the estimation of the Eq. (7) should be small.12

5. Empirical results

Table 3 provides some statistics for the three-digit SIC industries, including the
average percentage of foreign sales and foreign asset holdings of the firms in the
sample. As these numbers indicate, the multinationals in the sample have fairly large
volumes of foreign sales and foreign asset holdings in percentage terms. The share
of foreign sales averages from 27.1% in SIC 267 to 38.7% in SIC 387, and the share
of foreign assets from 28.1% in SIC 382 to 33.6% in SIC 384.

12
See a detailed discussion in Grossman and Levinsohn (1989).
 T. Gao / Journal of International Money and Finance 19 (2000) 117–134 129

Table 4
Estimation of Eq. (13)b

冘a 冘a 冘a y ⫺冘a
n1 n2 n3 n4

A:rit⫺rft=bi(rmt⫺rft)+(fi1sit+fi2xit+fi3)(⌬et⫺q0⫺ R,j Rt−j ⫺ m,j mt−j ⫺ y,j t−j TB,j TBt−j ⫺

j⫽1 j⫽1 j⫽1 j⫽1

冘a
n5

p,j pt−j )+mit

j⫽1

f1 f2 f3
Estimates 2.056a ⫺2.135a ⫺0.281
(0.721) (0.839) (0.175)
adj. R2=0.154

B:rit⫺rft=bi(rmt⫺rft)+(fi1sit+fi2xit+fi3)(et⫺q0⫺q1et−1)+mit
f1 f2 f3
Estimates 2.058a ⫺2.275a ⫺0.233
(0.728) (0.847) (0.175)
adj. R2=0.149

a
Statistically different from zero at 5% level, two-tailed test.
b
The estimations use OLS. Other parameter estimates are not reported in the table. Standard errors
are in the parentheses.

The OLS estimates of the parameters f1, f2 and f3 in Eq. (13) for all firms across
industries are collected in panel A of Table 4. In the estimation, industry dummies
are included to allow for a different b for each industry. The results are consistent
with our predictions: the estimate of f1 is positive and statistically significant at the
5% level, and the estimate of f1 negative and also statistically significant at the 5%
level. In panel B of Table 4, the alternative exchange rate process is used. This
change does not lead to much difference in the results. At the values of f1 and f2
in panel A, a 10 percent unanticipated depreciation of the dollar would lead to a 6.9
percent increase in the abnormal stock return through foreign sales and a 6.1 percent
decrease in the abnormal stock return through foreign production for an average firm
with si=0.336 and xi=0.285 (these are means in the sample).
Now let us turn to the two-stage estimation. Table 5 presents the estimate of b

Table 5
Estimated b for each industrya

OLS estimates of b for

rit⫺rft=b(rmt⫺rft)+⑀t
Industry 267 281 283 353 367 382 384

b 1.078 1.037 1.009 1.189 1.166 0.993 0.901

(0.084) (0.063) (0.056) (0.129) (0.095) (0.076) (0.165)
R2 0.231 0.262 0.241 0.170 0.109 0.128 0.080

a
Note: Standard errors are in the parentheses.
130 T. Gao / Journal of International Money and Finance 19 (2000) 117–134

for each industry by OLS estimation of rit⫺rft=b(rmt⫺rft)+⑀it in the first stage. As

usual, the market portfolio return rmt is highly significant in the regressions. Firms
within an industry are treated as if they had the same technology and capital structure
and therefore had the same risk measure of b.
Then the abnormal stock market return series (rit⫺rft)⫺b̂(rmt⫺rft) is constructed
for each firm by using its industry b̂. At the same time, exchange rate news needs
to be estimated. For each industry, volumes of exports to the major U.S. trading
partners are used as the weights to construct the export-weighted exchange rate. Two
sets of exchange rate news, deut, are obtained from the residuals of the estimations
of Eqs. (4) and (5) respectively. In the estimation of Eq. (5), the approach of nested-
hypothesis testing similar to Grossman and Levinsohn (1989) are used to determine
how many lags are to be used.
After (rit⫺rft)⫺b̂(rmt⫺rft) and dêut are available, the second stage of the proposed
estimation is performed by pooling all sample firms to estimate Eq. (14). By doing
this, we implicitly assume that fi1, fi2 and fi3 are the same across all sample firms,
Separate estimations applied to individual industries will be presented later, and the
weakness of these estimations will be assessed.
The results are collected in Table 6. In panel A of Table 6, exchange rate news
is constructed from the estimation of Eq. (5). As Table 6 shows, the estimated coef-
ficients again have the signs as theory predicts: f1 is positive, f2 is negative, and
both of them are statistically significant at 5% level. The residual effect f3 is negative
and insignificant. Panel B presents the estimates with exchange rate news constructed

Table 6
Estimation of the second stage Eq. (7)b

Second stage: the estimation of

rit⫺rft⫺b̂i(rmt⫺rft)=(f1si+f2xi+f3)dêut+mit

A:
with Exchange Rate News dêut Constructed from
⌬et=q0+⌺nj=1 n2
1 aRj Rt−j +⌺ j=1 amj mt−j +⌺nj=1 n4
3 ayj yt−j +⌺j=1 aTB,j TBt−j +⌺nj=1
5 ap,j pt−j +deut

f1 f2 f3

Estimates 1.997a ⫺2.025a ⫺0.111

(0.788) (0.919) (0.232)

B:
with Exchange Rate News d̂eut Constructed from
et=q0+q1et−1+deut
f1 f2 f3

Estimates 1.981a ⫺2.024a ⫺0.165

(0.748) (0.869) (0.220)

a
Statistically different from zero at 5% level, two-tailed test.
b
The estimates use the random effects model with time components. Standard errors are in the parenth-
eses.
 T. Gao / Journal of International Money and Finance 19 (2000) 117–134 131

from Eq. (4). The values of the coefficients f1, f2, and f3 from this two-stage
approach are quite comparable to those from the OLS estimation.
Table 7, organized in a way similar to Table 6, presents the final estimates for
the alternative specification, Eqs. (12) and (5). The results here are consistent with
those in Table 6. This indicates that the estimates are not sensitive to the choice
between a single-factor market model and a multi-factor one. Overall they are not
sensitive to the choice between the two exchange rate processes.
Interestingly, if one calculates the total effect of exchange rate news on the stock
return at the means of sit and xit it is quite small. The mean of sit for all firms over
the sample period is 0.336; that of xit is 0.285; (f̂1si+f̂2xi+f̂3) evaluated at these
values of sit and xit from Table 6, panel (A), is 0.205. This may explain why many
studies have come to the conclusion that exchange rate movements do not signifi-
cantly affect firms’ profitability. But this study is able to identify two channels
through which the profitability of firms is influenced by the exchange rate. The over-
all effect is the sum of a significant adverse effect of exchange rate news through
foreign production and a significant positive effect through foreign sales when there
is a depreciation shock. This will shed some light on understanding a multinational’s
decisions on sales and production, and how exchange rate risk can be practically
reduced through these decisions. As far as the stock market is concerned, the results
support the notion that the stock market correctly reveals the effect of exchange
rate news.
The model (Eqs. (7) and (5)) is also estimated separately for each industry. The
results are presented in Table 8. As one can see, for almost all the seven industries,
the signs of estimates of f1 and f2 confirm our theoretical predictions. With exchange
rate news dêut constructed from Eq. (5), f1 is positive for all industries, f2 is negative
for all but SIC 281 and 283. A similar pattern can be found when we use dêut derived
from Eq. (4). However, compared to the results in Table 6, the values of the estimates
vary substantially, and their statistical significance has been reduced. Two factors
may contribute to this. First, multinationals within an industry typically have similar
characteristics such as the shares of foreign sales and foreign asset holdings. To
identify f1, f2 and f3, cross-sectional variation in xit and sit is important since these
two variables are usually stable over time for each firm. If the data on firms in the
same industry provides little cross-sectional variation, the estimation is likely to yield
statistically insignificant estimates. Second, the number of firms for each industry is
small, ranging from 5 to 18. The small number of within-industry cross-sectional
units may not be enough to correctly identify the coefficients to be estimated. The
results in Gardner (1986) are similar to the estimates presented in Table 8. Gardner
uses a sample of only eight firms and treats xit and sit as completely fixed for each
firm over the sample period.

6. Concluding remarks

The impact of exchange rate movements on the profitability of firms has impli-
cations for macroeconomic theory and policy as well as for the decisions of firms
 132

Table 7
Estimation of the second stage Eq. (12)b

Second Stage: the estimation of

rit⫺rft=ci+p1UNEMNEWS+p2PPNEWS+p3MNEWS+p4ENNEWS+p5AGGNEWS+p6WNEWS+(fi1sit+fi2xit+fi3)dêut+mit

A:
with Exchange Rate News dêut constructed from
n1 n2 n3 n4 n5

⌬et+q0+ 冘 aRj Rt−j +

冘 amj mt−j +
冘 ayj yt−j +
冘 aTB,j TBt−j + ap,j pt−j +deut
冘
j⫽1 j⫽1 f
j⫽11 j⫽1 f2 j⫽1 f3 p1 p2 p3 p4 p5 p6

Estimates 1.912a ⫺1.917a 0.133 ⫺0.131 ⫺2.122 ⫺0.456 ⫺0.243 ⫺0.243 ⫺0.031
(0.790) (0.922) (0.275) (0.232) (1.325) (0.416) (0.288) (1.270) (0.116)

B:
with Exchange Rate News d̂eut Constructed from
et=q0+q1et−1+deut
f1 f2 f3 p1 p2 p3 p4 p5 p6

Estimates 1.684a ⫺2.053a 0.250 ⫺0.130 ⫺2.126 ⫺0.457 ⫺0.242 ⫺0.243 ⫺0.031
(0.745) (0.869) (0.265) (0.232) (1.324) (0.416) (0.288) (1.270) (0.116)

a
T. Gao / Journal of International Money and Finance 19 (2000) 117–134

Statistically different from zero at 5% level, two-tailed test.

b
The estimates use the fixed effects model. Standard errors are in the parentheses.
 T. Gao / Journal of International Money and Finance 19 (2000) 117–134 133

Table 8
Separate estimations of Eq. (7) for individual industriesc

Second Stage: the estimation of

rit⫺rft⫺b̂i(rmt⫺rft)=(f1sit+f2xit+f3)dêut+mit

A: with Exchange Rate News dêut constructed from

冘a R +冘a m +冘a y +冘a 冘a

n1 n2 nj n4 n5

⌬et=q0+ Rj t−j mj t−j yj t−j TBj TBt−j + p,j pt−j +deut

j⫽1 j⫽1 j⫽1 j⫽1 j⫽1

Industry 267 281 283 353 367 382 384

f1 7.137b 0.252 0.048 7.187 2.545 2.316 1.245

(3.913) (1.842) (1.413) (4.445) (2.786) (2.720) (1.165)
f2 ⫺3.363 0.447 0.166 ⫺3.734 ⫺5.258 ⫺4.599 ⫺2.903b
(3.814) (1.786) (1.576) (4.307) (3.411) (3.303) (1.515)
f3 ⫺1.583a ⫺0.425 0.285 ⫺1.065 ⫺0.540 ⫺0.467 0.121
(0.570) (0.356) (0.304) (1.185) (1.041) (1.108) (0.349)

B: with Exchange Rate News

dêut Constructed from
et=q0+q1et−1+deut
Industry 267 281 283 353 367 382 384

f1 1.321 0.283 0.884 4.611 2.316 1.245 4.589

(2.739) (1.694) (1.343) (4.273) (2.720) (1.165) (3.862)
f2 ⫺0.117 0.418 ⫺0.597 ⫺2.320 ⫺4.599 ⫺2.903b ⫺4.365
(2.518) (1.638) (1.500) (4.186) (3.303) (1.515) (4.964)
f3 ⫺0.368 ⫺0.472 0.144 ⫺0.730 ⫺0.467 0.121 ⫺0.222
(0.399) (0.337) (0.287) (1.139) (1.018) (0.349) (0.885)

a
Statistically different from zero at 5% level, two-tailed test.
b
Statistically different from zero at 10% level, two-tailed test.
c
The estimations use the random effects model. Standard errors are in the parentheses.

on production, sales, pricing strategy and financial operations. In the corporate world,
such an impact is often self-evident. However, empirical research on the profitability
effect of the exchange rate has so far produced mixed results.
In this paper, we recognize the potential of temporal instability of the conven-
tionally defined exchange rate exposure, and propose an empirical model relating
exchange rate exposure to a multinational’s foreign sales and production positions.
Theory predicts that an unexpected depreciation of the domestic currency will cause
a positive abnormal return proportional to the firm’s share of foreign sales in its
total sales, and a negative abnormal return proportional to the firm’s share of pro-
duction located in foreign countries. The overall impact of exchange rate news is
the sum of these two opposite effects and a residual effect.
The model is applied to a sample of eighty U.S. multinational firms for which
information on foreign sales and assets is available. In contrast to previous findings,
the empirical study in this paper suggests that the stock market correctly reveals the
profitability effects of unanticipated exchange rate changes predicted by theory, and
134 T. Gao / Journal of International Money and Finance 19 (2000) 117–134

these effects are statistically significant, The overall small effect of exchange rate
news on the sample firms may be the result of medium- or long-run adjustments
made by the multinational firms on production and sales. The findings in this paper
provide some plausible explanation for the mixed empirical results in the literature.

Acknowledgements

I would like to thank Alan Deardorff, Jim Levinsohn, Bob Stern, and Bernard
Yeung for their helpful comments and suggestions. Comments from the editor and
an anonymous referee are greatly appreciated.

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