The DAX and the Dollar: The Economic Exchange Rate Exposure of German Corporations

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1 The DAX and the Dollar: The Economc Exchange Rate Exposure of German Corporatons Martn Glaum *, Marko Brunner **, Holger Hmmel *** Ths paper examnes the economc exposure of German corporatons to changes n the DM/US-dollar exchange-rate. Our work contrbutes to the exstng body of lterature n the followng ways. Frstly, we pont out conceptual problems of prevous attempts to estmate economc exposure. Secondly, we fnd that German frms are sgnfcantly exposed to changes n the DM/US-dollar rate. However, our results are unstable over tme. The paper has been accepted for publcaton n the Journal of Internatonal Busness Studes, 31, 4 (fourth quarter 2): * Martn Glaum s Professor of Internatonal Management and Communcatons at Justus- Lebg-Unverstät, Lcher Str. 62, Gessen, Germany. ** Marko Brunner and *** Holger Hmmel are Research Assstants at the same nsttuton. The authors thank Cheol Eun, Al Fatem, Sven Knoth, and the partcpants of the 1997 EIBA Annual Conference, the 1998 Global Fnance Assocaton Annual Conference, and the 2 European Fnancal Management Conference for helpful comments. We are also grateful to three anonymous referees whose comments helped us to mprove the paper. All remanng errors are the responsblty of the authors.

2 1 Introducton Dollar drves DAX, Dow and Dollar pull DAX upwards, US Dollar puts stock exchange on rght track 1 many headlnes such as these can be found n the German busness press. It appears to be establshed wsdom amongst journalsts and other pundts that the US dollar s an mportant drvng force of the German stock market. The explanaton gven for ths s as follows: a deprecaton of the Deutschmark mproves the poston of German frms vs-à-vs foregn compettors both n ther home market and n ther export markets. It wll therefore have a postve mpact on ther future cash flows and, consequently, on ther market value (vce versa for apprecatons). The frst major study on frms economc exposure to exchange-rate changes or the relatonshp between exchange rates and the value of frms was undertaken by Joron (199). Lookng at data for US frms over the perod 1971 to 1987, he found lttle support for the hypothess that the share prces of US frms are systematcally nfluenced by exchange-rate changes. Subsequent studes by Bartov & Bodnar (1994) and Cho & Prasad (1995) also faled to establsh a sgnfcant relatonshp between US share-prce returns and movements of the dollar. Although more recent studes [see, for nstance, Allayanns (1996), Mller & Reuer (1998a); Rees & Unn (1999); Bodnar & Wong (1999); Gao (2)] have found somewhat stronger evdence of exchange-rate exposures, the overall evdence on the ssue remans weak. In ths study, we nvestgate German frms' economc exposures to the US dollar. Our work contrbutes to the body of lterature n the followng ways. Frstly, we pont out conceptual problems n prevous attempts to model and estmate economc exposure. Secondly, we fnd that the values of German frms are sgnfcantly affected by changes n the DM/US-dollar exchange-rate. However, our results are unstable over tme, the exposure coeffcents of both the market and ndvdual frms dsplay pronounced swngs over tme. Model Specfcaton Followng Adler & Smon (1986), we measure economc exposure as the slope coeffcent from a regresson of stock returns on exchange-rate changes: (1) Rt = α + β et + ε t where α s a constant term, R t denotes securty s return n perod t, e t the contemporane-

3 2 ous exchange-rate change, and ε t s an error term. The coeffcent β represents the senstvty of company s stock returns to exchange-rate changes. If the exchange rate s quoted as DM per one unt of the foregn currency, a postve value of β means that a deprecaton of the DM corresponds to an ncrease n the value of frm. 2 Joron s (199) estmatons are based on an alternatve model. He ntroduced the return of the market, R mt, as a second varable n model (1) to control for market movements: (2) Rt = α + β1 et + β 2 Rmt + ε t Equaton (2), however, rases the problem of nteracton between the market factor and the exchange rate. In order to deal wth ths multcollnearty, Cho & Prasad (1995) orthogonalzed the exchange-rate varable. Ths leads to the followng model: o (3) Rt = α + β1 et + β 2 Rmt + ε t where e t o are orthogonalzed exchange-rate returns. However, one has to be aware that the coeffcent β 1 both n model (2) and model (3) no longer reflects the full effect of exchangerate changes on company s returns and, therefore, ts economc exposure as defned by Adler & Smon (1986). Instead, t measures frm-ndvdual exchange-rate senstvty n excess of the market s exchange-rate reacton. Ths dfference n the nterpretaton of coeffcent β 1 leads to an mportant conceptual pont. To llustrate ths, let us assume that all German corporatons are affected by exchange-rate changes n exactly the same way. That s, f the DM deprecates all frms n the market experence postve returns of the same sze. In ths case, model (3) may not show any sgnfcant β 1 -coeffcents because the changes n the frms values would be completely captured by the market factor. As a result, one mght be led to conclude that German corporatons do not have any economc exposure to exchangerate changes. The dfference between model (1) and model (3) can be made more explct by decomposng the coeffcent of model (1): (1) (3) (4) β = β + β x β ) 1 ( M, e, M (1) β denotes the exchange-rate beta of model (1), or the total exchange-rate senstvty of an asset followng Adler & Smon (1986). (3) β 1 s the exchange-rate coeffcent measured by

4 3 model (3), or the frm-ndvdual exchange-rate senstvty n excess of that of the market (drect exposure effect). The second term results from the nteracton of the market s exchange-rate senstvty β ) wth the frm's senstvty to market movements β ). Ths ( M,e (,M ndrect, or market exposure effect has to be added to the drect exposure n order to arrve at the total exchange-rate senstvty. If the market as a whole s totally uncorrelated wth the exchange rate, the ndrect effect becomes rrelevant. In ths case, the coeffcents of model (1), (2) and (3) wll be dentcal. One may note further, that the β secondly, an ndvdual (3) 1 of all frms n a market have to add up to zero 3 and that, (3) β1 of zero does not mply that ths frm s value s nsenstve to exchange-rate changes; rather, ts senstvty s exactly the same as the market s [also see Bodnar & Wong (1999) on ths pont]. Data We use data for the perod from January 1974 to December The exchange-rate data was obtaned from the Deutsche Bundesbank; stock and ndex data s from the Karlsruher Kaptalmarkt-Datenbank (KKMDB). Our corporate sample conssts of all frms lsted n the most mportant segment (amtlcher Handel) of the Frankfurt/Man stock exchange. The market ndex we employ s the Deutsche Akten Forschungsndex (DAFOX), a valueweghted ndex whch comprses all shares n the amtlche Handel. Several questons arse wth regard to the exchange-rate data to be used n a study such as ths. Frst, to prevent possble averagng-out effects, we do not use exchange-rate ndces or monthly averages. Instead, we use daly changes of a sngle exchange rate, namely the DM/US-dollar exchange rate. As we have ponted out already, the US dollar s often seen as a drvng force of the German stock market. Secondly, we use nomnal returns n ths study, snce the low volatlty of nflaton rates means that most of the changes n nomnal exchanges rates also translate nto changes n real exchange rates. Several prevous studes have used both nomnal and real returns and have come to the concluson that the choce has no sgnfcant mpact on the results. Thrdly, numerous emprcal studes have shown that tme seres for major exchange rates are extremely hard to dstngush from random walks [see Taylor (1995) for a lterature revew]. If exchange-rate movements can best be descrbed wth a random-walk model, the best predctor of future exchange rates s the current spot rate and all changes can be nterpreted as unantcpated.

5 4 It s unrealstc to assume that frms exchange-rate exposures have remaned constant over a perod of 24 years. Therefore, followng Engel & Hamlton (199), we dvde the tme seres of the DM/US-dollar exchange rate nto four sub-perods (see Fgure 1). The frst sub-perod runs from January 1974 to December Durng ths tme, the dollar experenced a prolonged deprecaton aganst the DM. Durng sub-perod II (January 198 to February 1985), the dollar apprecated strongly. Ths was followed by a steep fall between March 1985 and June 1987 (sub-perod III). The last sub-perod s from July 1987 to December Fgure 1: The DM/US-dollar exchange rate from January 1974 to December DM / US Dollar (January December 1997) /1/74 1/11/77 1/9/81 2/7/85 2/5/89 2/3/93 31/12/97 Stock returns and exchange-rate changes are calculated as percentage changes. All tme seres were found to be statonary usng an Augmented Dckey-Fuller test. Regressons are estmated by ordnary least squares (OLS). Snce error terms n our regressons are serally correlated and heteroscedastc, we employ the Newey-West correcton procedure throughout the paper [see Newey & West (1987)]. Results US-Dollar Exposures of German Corporatons In the followng, we report estmaton results for ndvdual German frms total economc exposure usng model (1). We frst run regressons wth all frms that have complete shareprce tme seres for the total perod and the four sub-perods, respectvely. The results are

6 5 shown n Panel A of Table 1. For the total perod, 39 out of 71 frms (55%) have a sgnfcant US-dollar exposure, and all of these are postve. At frst sght, these results seem to confrm the hypothess that German frms tend to beneft from deprecatons of the DM and to be negatvely affected by apprecatons. Table 1: US-dollar exposures of German corporatons [Model (1)] Model: Full Perod (1/74-12/97) Panel A: R t = α + β e + ε Sub-perod I (1/74-12/79) t t Sub-perod II (1/8-2/85) wthout lqudty restrcton Sub-perod III (3/85-6/87) Sub-perod IV (7/87-12/97) Sample sze (no. of frms) Mean exposure coeffcent (Standard devaton) Sgnf. exposure coeff. a (% of total frms) Sgnf. postve coeff. (% of sgnfcant coeffcents) Sgnf. negatve coeff. (% of sgnfcant coeffcents).18 (.74) 39 (55%) 39 Panel B:.63 (.74) 32 (21%) (.123) 77 (68%) 2 (3%) 75 (97%) wth lqudty restrcton.155 (.155) 61 (34%) 6 (98%) 1 (2%) Total no. of frms Mean exposure coeffent (Standard devaton) Sgnf. exposure coeff. a (% of total frms) Sgnf. postve coeff. (% of sgnfcant coeffcents) Sgnf. negatve coeff. (% of sgnfcant coeffcents) a sgnfcant at 5% (two-sded test).171 (.6) 24 (89%) (.69) 27 (45%) (.82) 49 (98%) (.134) 52 (71%) (.135) 83 (74%) (.79) The results for the sub-perods, however, reveal an nterestng phenomenon. In sub-perods I, III, and IV, practcally all sgnfcant exposure coeffcents are postve. In these perods, deprecatons of the DM were nterpreted favourably by nvestors (vce versa for apprecatons); ths corresponds to conventonal expectatons. Further, coeffcents are larger and the level of sgnfcance s hgher n the last two perods than n the frst. In sub-perod II, however, 97% of the sgnfcant coeffcents are negatve. That s, durng the strong apprecaton of the US-Dollar n the frst half of the 198s, German stocks reacted aganst conventonal expectatons to party changes. Whle prevous studes have also shown that the relaton between exchange-rate changes and stock-prce returns s not stable over tme none of them have reported systematc tme varaton of exposure coeffcents. Ths puzzlng result wll be addressed further below (see secton 2).

7 6 In comparson to the US market, the German stock market s much smaller and less lqud. Hence, nfrequent tradng or prces determned at low lqudty may ntroduce nose, or even a bas nto our results (also see Göppl et al on ths pont). We therefore ntroduce a lqudty requrement. We compute the ratos of ndvdual stocks turnovers to the average turnover for each year. Only stocks satsfyng a threshold rato n each of the years are ncluded nto our sample. In Panel B of Table 1, we report results for a lqudty constrant of 1%, that s, for each perod we nclude only frms that have a yearly turnover of at least 1% of the average turnover n each year of that perod. In comparson to the results wthout lqudty restrcton, the average exposure coeffcents are hgher, the standard devatons are lower, and the proporton of sgnfcant exposures rses markedly. Further, n the full perod, and n subperods I, III, and IV, all sgnfcant exposure coeffcents are postve; n sub-perods II, all of them are negatve. The ntroducton of a lqudty restrcton thus leads to clearer and more pronounced results. In the followng, we apply the orthogonalzed two-factor model [model (3)], n order to demonstrate the nfluence of the aforementoned ndrect exposure coeffcent and to compare our fndngs wth those of earler studes. The results are presented n Table 2. Smlar to prevous studes, we fnd both postve and negatve coeffcents. The means of the coeffcents are close to zero n all perods, and the porton of sgnfcant coeffcents s much lower than wth model (1). In fact, gven the already mentoned fact that the ndrect exposures of all frms n a market have to add up to zero [Bodnar & Wong (1999)], ths result s hardly surprsng. A comparson of the results n Table 1 and Table 2 reveals clear dfferences n magntude, sgn, and sgnfcance. These dfferences are due to the ndrect exposure effect whch s not taken nto account by model (3). The followng example should llustrate the dfference between the two models. Estmated wth model (3), Volkswagen has an exposure coeffcent of.31 for the total sample perod. The coeffcent s not sgnfcantly dfferent from zero. By tself, ths would seem puzzlng, because Volkswagen s a strongly export-orented German car manufacturer whch n the lterature has even ganed some notorety for ts pronounced US-dollar exposure [see, for nstance, Srnvasulu (1981), Oxelhem & Whlborg (1998)]. However, model (3) only measures VW's drect exposure, and one has to add the ndrect exposure n order to arrve at total exposure [see equaton (4)]. Multplyng the German stock

8 7 market s exchange rate senstvty of.154 wth Volkswagen s market beta of 1.44, the ndrect exposure effect n Volkswagen s case s.222 for the total perod. Addng ths to the drect exposure of.31, one arrves at a total exposure coeffcent of Followng equaton (4), ths s equal to the coeffcent for Volkswagen whch we have estmated wth model (1). Table 2: US-dollar exposures of German corporatons [Model (3)] Model: R Full Perod (1/74 12/97) Panel A: o t = + β1 et + β 2 α R + ε Sub-perod I (1/74-12/79) mt t Sub-perod II (1/8-2/85) wthout lqudty restrcton Sub-perod III (3/85-6/87) Sub-perod IV (7/87-12/97) Sample sze (no. of frms) Mean exposure coeffcent (Standard devaton) Sgnf. exposure coeff. a (% of total frms) Sgnf. postve coeff. (% of sgnfcant coeffcents) Sgnf. negatve coeff. (% of sgnfcant coeffcents) -.16 (.46) 22 (31%) 7 (32%) 15 (68%) Panel B:.7 (.59) 7 (5%) 5 (71%) 2 (29%) -.15 (.65) 12 (11%) 5 (42%) 7 (58%) wth lqudty restrcton.15 (.8) 18 (1%) 8 (44%) 1 (56%) Total no. of frms Mean exposure coeffent (Standard devaton) Sgnf. exposure coeff. a (% of total frms) Sgnf. postve coeff. (% of sgnfcant coeffcents) Sgnf. negatve coeff. (% of sgnfcant coeffcents) a sgnfcant at 5% (two-sded test) -.4 (.56) 14 (52%) 6 (43%) 8 (57%).9 (.58) 4 (7%) 3 (75%) 1 (25%) -.16 (.54) 6 (12%) 1 (17%) 5 (83%) Tme Varaton n the US-Dollar Exposures of German Corporatons.34 (.74) 16 (22%) 8 (5%) 8 (5%) -.13 (.135) 21 (19%) 6 (29%) 15 (71%).28 (.65) 1 (28%) 5 (5%) 5 (5%) The results we obtaned for dfferent tme perods motvated us to analyse the tme varaton n the exchange-rate coeffcents n greater detal usng a movng-wndow regresson approach. Startng wth data from January 1974 onwards, we estmate equaton (1) for a perod of 25 tradng days. We then move our tme wndow thrty tradng days forward and run the regresson agan. By dong ths step by step over the total perod, we obtan a seres of 21 exchange-rate betas. Ths seres gves nsght nto the behavour of the exchange-rate exposure of German stocks over tme. Fgure 2 plots the dollar senstvty of the DAFOX over tme. The shaded areas mark the perods for whch sgnfcant exposure coeffcents were obtaned (1% level). Obvously, the

9 8 US-dollar senstvty of the German stock market dsplays large swngs over tme. From md to early 1979, the DAFOX reacted sgnfcantly to the fall of the dollar, and n a way that s consstent wth conventonal expectatons. From Aprl 198 to February 1984, that s, durng the rse of the dollar, the regressons produce sgnfcant negatve coeffcents. Between late 1985 and November 1987, when the dollar fell sharply, the coeffcent surges. 5 From md-1989 onwards, t fluctuates strongly around zero and t starts to rse strongly agan n late Fgure 2: Movng-wndow regresson for the DAFOX DAFOX FX-Beta Over Tme (Regresson Wndow: 25 Days, Step Sze: 3 Days) 2/ / / /1979 3/1985 4/ /1989 5/ / /1983 6/ /74 11/76 2/79 6/81 9/83 1/86 5/88 8/9 12/92 3/94 7/97 We also ran the movng-wndow regressons for the DAX and for the 3 ndvdual DAX stocks wth model (1) (not shown n the paper). The overall pattern s very smlar for all corporatons. Conclusons and Suggestons for Further Research Ths paper examnes the economc exposure of German corporatons to changes n the DM/US-dollar exchange-rate. Frstly, we pont out conceptual problems of prevous attempts

10 9 to estmate economc exposure. Secondly, we fnd that German frms are sgnfcantly exposed to changes n the DM/US-dollar rate. However, our results are unstable over tme. Our fndngs lead to the followng questons. Why do the exchange-rate exposures of German frms change over tme and, above all, why do they become negatve n certan perods. As has been ponted out, one would expect changes n the frms exposures over tme as ther compettve stuaton changes. Wth ncreases n foregn drect nvestment, frms become less dependent on exports and thereby less senstve to changes n exchange rates [see Mller & Reuer (1998a)]. A change n the level of mport competton would also have an mpact on the exposures. Other factors leadng to ncreases or decreases n exposure coeffcents are changes n the structure of the frms foregn currency denomnated assets or labltes and changes n ther hedgng actvtes. If such changes are very pronounced, they may even explan negatve exposure coeffcents [see Booth & Rotenberg (199)]. However, whle the above determnants may explan fluctuatons of the exposures of ndvdual frms or ndustres over tme, t seems unlkely that they have caused the systematc fluctuatons of practcally all German frms exposures that we observe. It s also possble that the tme pattern reported here s due to omtted varables. In partcular, the nteracton between exchange rates and nterest rates may have a bearng on our results. If party changes are due to changes n nterest rates, as nterest rate party theory would predct, share prces may be affected because the market dscounts the frms future earnngs streams wth a dfferent dscount rate. Future research should therefore focus on the relatonshp between frm values, exchange rates, nterest rates, and possbly other macroeconomc varables [also see Oxelhem & Whlborg (1998) on ths pont]. A pont that also deserves attenton s the queston of why the values of some frms react more strongly to party changes than others. However, research nto the determnants of German corporatons exchange-rsk exposure s hampered by the fact that German fnancal accountng standards n the past dd not requre frms to report detaled nformaton on ther geographcal busness segments or on ther hedgng actvtes. Therefore, consstent data on foregn actvtes (e.g. overseas sales, assets, or profts) or the degree to whch exchange-rate rsks are managed s not readly avalable.

11 1 Notes 1 These quotes are from: Handelsblatt, March 6, 1997, p1; Handelsblatt, Aprl 16, 1997, p4; Handelsblatt, June 3, 1997, p43. 2 The model s based on the assumpton that share-prce reactons to exchange-rate changes are lnear and symmetrc. Mller & Reuer (1998b) suggest that real optons and prcng-tomarket strateges could lead to asymmetrc exposures. They fnd some support for ths hypothess for ther sample of US frms. 3 In a strct sense, ths only holds true f an equally weghted market portfolo s used. For detals, see Bodnar & Wong (1999). 4 That s, on average, Volkswagen-shares rse by.253% on the occurrence of a 1% ncrease n the DM/US-dollar rate. 5 Interestngly, the hghest pont s reached around the tme of the stock market crash of October If we exclude data for one month (md-october to md-november 1987), the coeffcents are somewhat lower; the overall pattern, however, s not changed. References Adler, Mchael & Davd Smon Exchange rsk surprse n nternatonal portfolos: Some equty markets are super-nomnal! Journal of Portfolo Management, Wnter: Allayanns, George Exchange rate exposure revsted. Workng paper, Unversty of Vrgna. Bartov, El & Gordon M. Bodnar Frm valuaton, earnngs expectatons, and the exchange-rate exposure effect. Journal of Fnance, 49(5): Bodnar, Gordon M. & M. H. Franco Wong Estmatng exchange rate exposure: Some weghty ssues. Workng paper, Unversty of Pennsylvana. Booth, Laurence & Wendy Rotenberg Assessng foregn exchange exposure: Theory and applcaton usng Canadan Frms. Journal of Internatonal Fnancal Management and Accountng, 2(1): Cho, Jongmoo J. & Anta M. Prasad Exchange rsk senstvty and ts determnants: A frm and ndustry analyss of U.S. multnatonals. Fnancal Management, 24(3): Engel, Charles & James D. Hamlton Long swngs n the dollar: Are they n the data and do markets know t? Amercan Economc Revew, 8(4): Gao, Tng. 2. Exchange rate movements and the proftablty of U.S. multnatonals. Journal of Internatonal Money and Fnance, 19: Göppl, Hermann, Torsten Lüdecke, Chrstan Schlag & Henrch Schütz The German equty market: Rsk, return, and lqudty. Workng paper, Unversty of Karlsruhe. Joron, Phlppe The exchange-rate exposure of U.S. multnatonals. Journal of Busness, 63(3): Mller, Kent D. & Jeffrey J. Reuer. 1998a. Frm strategy and economc exposure to foregn exchange rate movements. Journal of Internatonal Busness Studes, 29(3):

12 11 & Jeffrey J. Reuer. 1998b. Asymmetrc corporate exposures to foregn exchange rate changes. Strategc Management Journal, 19: Newey, Whtney K. & Kenneth D. West A smple, postve sem-defnte, heteroskedastcty and autocorrelaton consstent covarance matrx. Econometrca, 55(3): Oxelhem, Lars & Clas Whlborg Managng n the turbulent world economy - Corporate performance and rsk exposure. New York: John Wley. Rees, Wllam & Snjay Unn Exchange rate exposure among European frms: Evdence from France, Germany and the UK. Workng paper. Unversty of Glasgow. Srnvasulu, S. L Strategc response to foregn exchange rsk. Columba Journal of World Busness, 16(1): Taylor, Mark. P The Economcs of Exchange Rates. Journal of Economc Lterature, 33(March):