Exchange Rate Exposure of Chinese Firms at the Industry and Firm Level

• Published date: 01 August 2015
• DOI: http://doi.org/10.1111/rode.12162
• Author: Bo Tang
• Date: 01 August 2015

Exchange Rate Exposure of Chinese Firms at the

Industry and Firm Level

Bo Tang*

Abstract

This study investigates the exchange rate exposure of Chinese firms at the industry and firm level based on

the conventional capital asset pricing model (CAPM) framework. At the industry level, the dynamic condi-

tional correlation MGARCH (DCC MGARCH) estimates demonstrate that the market model and three-

factor model are appropriate for exposure measurements, and industry returns are more likely to be

exposed to unanticipated changes in the real exchange rate and the trade-weighted effective exchange rate,

particularly for manufacturing industries. At the firm level, although the seemingly unrelated regression

(SUR) estimates vary across markets, it is apparent that there is a relationship between firm size and expo-

sure effects, which also show that lagged exchange rate changes have significant exposure effects on firm

returns. This study finally suggests that non-financial firms should set up special commissions to hedge cur-

rency risks of their future cash flows.

1. Introduction

In the era of financial integration, exchange rate changes have considerable influences

on firm values during the transaction and operation process. The classical definition of

exchange rate exposure refers to the effect of unanticipated changes in the exchange

rate on firm values (Adler and Dumas, 1984; Jorion, 1990). Multinational firms are

subject to currency exposures by virtue of their global operations. Generally, three

types of typical risks caused by exchange rate changes affect firm values (Hakala and

Wystup, 2002; Shapiro, 2008): transaction exposure, translation exposure and operat-

ing exposure. The empirical literature on the exchange rate exposure of firm returns

has seen a dramatic increase since 2000 (Bodnar and Marston, 2002; Doukas et al.,

2003; Muller and Verschoor, 2006; Chue and Cook, 2008). Their objectives are to

examine the significant exposure effects of exchange rate changes on firm values, and

to further highlight the importance of hedging currency risks.

Since 2009, China has been the largest exporter and second largest importer in the

world. More than 200 countries and regions have trade connections with China.1

According to the report from the China Securities Regulatory Commission (CSRC),

more than 2500 Chinese listed firms are actively participating in the financial market

and around 60% of them are exporting firms. With the further opening to outside

world, an increasing number of Chinese exporting firms are seeking opportunities of

doing businesses overseas. However, the studies on the exchange rate exposure of

Chinese firms are still rare as a result of its particular exchange rate policy. Since

1994, the Chinese government merged the dual currency system and launched the

* Tang: Department of Economics, University of Sheffield, 9 Mappin Street, Sheffield, S1 4DT, UK.Tel:

+44-(0)114-222-3421; Fax: +44-(0)114-222-3458; Email: b.tang@sheffield.ac.uk. The author is grateful to

Juan Carlos Cuestas, Karl Taylor and the participants of international conference on “Exchange Rate,

Monetary Policy and Financial Stability in Emerging Markets and Developing Countries” in Leipzig for

their helpful comments. All remaining errors are the responsibility of the author.

Review of Development Economics, 19(3), 592–607, 2015

DOI:10.1111/rode.12162

© 2015 John Wiley & Sons Ltd

unified exchange rate policy. The daily floating range of RMB against USD was

restricted at 0.3%. The managed floating exchange rate system has been implemented

in China since July 2005. The floating range was expanded to 0.5% in 2007 and

further widened to 1% in 2012. In March 2014, the floating range was expanded to

2%.2

Motivated from the existing literature on the exchange rate exposure measurement

and the realities in China, this study aims to answer the following questions: (1) Do

Chinese firms suffer from exchange rate exposure under the managed floating

exchange rate system? If yes, which kind of exchange rate has the largest influence on

Chinese firms? (2) Under the conventional exchange rate exposure measurement

framework, which models fit with the industry and firm level exposure analyses? (3) Is

there a correlation between firm size and the exposure effect? (4) Do lagged exchange

rate changes have a significant impact on Chinese firms?

The exchange rate exposure of Chinese firms in this study is investigated from the

following aspects. First, the capital market approach and the cash flow approach are

applied to measure the exchange rate exposure of Chinese firms at the industry and

firm level separately, which are estimated by a macroeconometric approach and a

microeconometric approach, respectively. Second, exposure effects from different

exchange rates are investigated individually to observe which one has the largest

influence. Third, three types of models based on the capital asset pricing model

(CAPM) framework are separately estimated to identify the most suitable model.

Fourth, the firm level exposure is estimated by examining the size effect of different

types of firms (large, medium and small firms) using the seemingly unrelated regres-

sion (SUR) approach. Last, since the daily floating range of the RMB exchange rate is

restricted within a narrow band, therefore the effect from lagged exchange rate

changes will also be examined in the study.

The remaining parts of this study are constructed as follows. Section 2 reviews the

approaches for measuring exchange rate exposure. Data and preliminary statistics are

given in section 3. Theoretical models and econometric strategies are discussed in

section 4. Section 5 details the empirical results and the last section concludes.

2. Exchange Rate Exposure Measurement

It is not easy to measure the exchange rate exposure in a simple way, at least relating

to the translation and operating exposure (Holton, 2003; Papaioannou, 2006). The

widely used approaches in the extant literature are the value-at-risk (VaR) (Jorion,

1996; Berkowitz and O’Brien, 2002), the capital market approach and the cash flow

approach. There are also some theoretical models designed by researchers based on

different assumptions, which could be linear, nonlinear, symmetric or asymmetric

models (Flood and Lessard, 1986; Dekle and Ryoo, 2007), but the optimum model for

measuring exchange rate exposure should take different realities into consideration.

In this study, the capital market approach and the cash flow approach fit with the

industry and firm level exposure measurements, respectively.

Capital Market Approach

A considerable amount of studies measure the currency exposure building upon the

framework of capital asset pricing model (CAMP) (Adler and Dumas, 1984; Jorion,

1990; Dominguez and Tesar, 2006; Chue and Cook, 2008; Du and Hu, 2012). The

EXCHANGE RATE EXPOSURE OF CHINESE FIRMS 593

© 2015 John Wiley & Sons Ltd