How exchange rate fluctuations affect stock prices

There is obscurity between exchange-rate changes and stock prices, but a new study suggests that export-driven revenues are closely tied to the dollar’s strength

Featured faculty: Zhou Yuqing
Written by Shirley Lau

Most countries rely on the US dollar for trade and finance, making the greenback the preferred currency for international transactions. It might seem obvious that currency fluctuations would affect American companies’ profitability, which would, in turn, affect their share price.

A strong dollar reinforces the US dominance in the global market and helps reduce inflation by making imports cheaper. However, a weak dollar would make American goods more affordable to buy abroad, which could boost domestic manufacturing due to rising demand and, eventually, result in higher revenues and stock prices.

Nevertheless, numerous studies have failed to find a consistent, significant relationship between exchange rate exposure and stock returns. Existing literature has identified meaningful effects only in specific industries or certain companies, while other studies found that exchange rate changes have little to no impact on stock prices. This phenomenon is called “the exchange rate exposure puzzle” and continues to perplex many.

Zhou Yuqing, an Assistant Professor of Accounting at the Chinese University of Hong Kong (CUHK) Business School, highlights a gap in our understanding of the true dynamics of currency movements at play and the importance to revisit the above puzzle.

“The disconnect between what financial theory predicts and what empirical research observes is perhaps surprising, given the sheer importance of international trade and frequent large exchange-rate movements today,” she says. “The phenomenon might be even more perplexing when it comes to publicly listed companies in the US, an economy in which public firms are solidly embedded in the global economy.”

In 2019, exports of goods and services from the US amounted to around 11.7 per cent of its economy, up from 5.6 per cent in 1970. Much of this international trade was conducted by large publicly traded companies. Meanwhile, exchange rates between the US dollar and other currencies experienced great fluctuations over the years. From 1999 to 2019, the euro varied between €0.84 and €1.59 against the US dollar, the Japanese yen between ¥80 and ¥360, and the Chinese yuan between 1.55 and 8.72 yuan.

One may assume that a weak association between exchange rate changes and stock returns is due to financial or operational hedging, which could have mitigated or even eliminated the impact of exchange rate movements. Yet the question remains whether exchange rate exposures are economically meaningful and useful for investors in financial markets.

In a paper titled The effects of exchange rate movements on publicly traded US corporations, Professor Zhou and Ivo Welch of the University of California, Los Angeles, revisited the exchange rate puzzle and finally found strong effects of exchange rate movements on exports, sales, profits and stock prices of publicly listed US companies, and the impact has actually grown stronger over time.

“Larger and more export-oriented firms are likely to engage in more hedging strategies to protect themselves against the risks associated with exchange rate movements.”

Professor Zhou Yuqing

Finding the missing link

Using data from the US Census Bureau’s Longitudinal Foreign Trade Transactions Database, which links individual import and export transactions from 1992 to 2016 to the relevant firms, the researchers were able to focus on firms that were more likely to experience exchange rate fluctuation effects. The data made it possible to generate an independent variable: a firm-specific exchange rate change weighted by the export value, thus further sharpening the focus on the effects of exchange rate movements.

The improved metric enabled the researchers to investigate how US firms involved in export transactions have been affected by exchange rate movements in terms of the size of their exports, sales and profits. The study found a meaningful association between stock prices and exchange rate movements, as well as between firm profitability and exchange rate movements.

By virtue of the improved exchange rate measure, as well as the different types of samples adopted for the study, Professor Zhou first confirmed that there was a significant connection between exchange rate movements and exports. A one per cent change in firm-specific US dollar exchange rate was related to a 0.4 to 0.6 per cent change in exports. After 2004, the coefficients rose to 0.6 per cent. More specifically, it was found that exchange rate movements mainly affected two types of firms: large-sized firms and companies that were already involved in exports in the 1990s.

Next, Professor Zhou revisited the puzzle and found that daily stock returns responded positively to exchange rate changes. A one per cent change in the exchange rate was associated with a 0.06 per cent change in daily stock returns. This relationship has strengthened in recent years. Between 2004 and 2016, a one per cent change in the exchange rate explained a 0.09 per cent change in daily stock returns.

There was also a strong connection between firm profitability and the exchange rate, with a 1 per cent change in the exchange rate associated with a 0.33 per cent change. The magnitude of the elasticity was, however, lower for larger firms, suggesting that although firms had not fully hedged out the financial statement effects of exchange-rate movements, larger and more export-oriented firms engaged in relatively more hedging against exchange rate risks.

“Larger firms typically have fixed costs, so changes in sales have a greater impact on their profitability. If sales fluctuate, these fixed costs can significantly impact their profit margins,” Professor Zhou says. “As a result, larger and more export-oriented firms are likely to engage in more hedging strategies to protect themselves against the risks associated with exchange rate movements.”

Exchange rate can affect domestic sales too

Apart from exports, the study identified strong effects of exchange rate changes on firms’ total sales. A one per cent depreciation in the exchange rate increased sales by about 0.27 per cent. Remarkably, total sales, which encompassed both domestic and international transactions, appeared more sensitive to exchange rate changes than exports. This suggests that exchange rate changes can affect not only exports but also domestic competitive dynamics.

The insights of the study may serve as a reference for those involved in financial decision-making and “may help corporate managers, stakeholders like investors, and policymakers to understand and manage exchange-rate risks in an increasingly interconnected global economy,” says Professor Zhou.

The study also indicates that hedging is not an effective factor in mitigating exchange rate effects due to various limitations, Professor Zhou notes. “Some firms are not fully aware of the effects of exchange rate movements. Others may have limited resources to be allocated to hedge exchange rate movements even when they understand the effects.”

“Public firms need to pay more attention to exchange rate movements. They should also improve exchange rate risk management by combining financial and operational hedging strategies,” she adds. “Moreover, firms can conduct analyses to assess their own exchange rate impacts and react accordingly. They need to ensure transparent communication with investors about their exchange rate risk exposure and their mitigation efforts. These steps can help reduce related risks.”