Foreign Exchange Exposure Elasticity and Financial Distress

• Author: Laura T. Starks,Kelsey D. Wei
• DOI: http://doi.org/10.1111/fima.12016
• Published date: 01 December 2013
• Date: 01 December 2013

Foreign Exchange Exposure Elasticity

and Financial Distress

Kelsey D. Wei and Laura T. Starks∗

Financially distressed firms have limited ability to manage exchange rate exposure over time

which could cause their fundamental value to be sensitive to the cash flow volatility related

to currency movements. Accordingly, we hypothesize that the likelihood and costs of financial

distress help explain cross-sectional variations in return sensitivity to currency movements. We

find that the level of exchange rate exposure elasticity is related to proxies for the likelihood of

financial distress, growth opportunities, and product uniqueness. Further, firms with a greater

likelihood and higher costs of financial distress exhibit greater abnormal returns in response to

large exchange rate shocks.

Movements in exchange rates can havea dramatic effect on a fir m’s financial performance. For

example, for the fiscal year ending March 31, 2009, Honda announced that exchange rate changes

hurt the firm’s profits to a larger extent than did falling sales over the same period (Greimel,

2009). Due to the magnitude of the potential effects of exchange rate exposure, a large body of

work examines the scale, as wellas sources, of this exposure. Specif ically, prior research explores

the cross-sectional variation in exchange rate exposure due to differences in firms’ competition,

hedging, liquidity, leverage, and foreign sales (Allayannis and Ihrig, 2001; Allayannis and Ofek,

2001; Bartram and Karolyi, 2006; Doidge, Griffin, and Williamson, 2006; Francis, Hasan, and

Hunter, 2008; He and Ng, 1998; Jorion, 1990; Williamson, 2001). In this paper, we argue that

another important factor affecting variation in firms’ exchange rate exposure is financial distress.

A key finding of previous research is that although exchange rate movements have significant

effects on firms’ cash flows and operations, there exist relatively weak correlations between

exchange rate movementsand stock prices (Griff in and Stulz, 2001; Williamson,2001). Evidence

also suggests that this disparity results as many firms are able to manage their foreign exchange

exposure by passing through its effects to customers or by engaging in financial or operational

hedging (Carter, Pantzalis, and Simkins, 2003; Bartram, Brown, and Minton, 2010).1Thus, for

the average firm with sufficient opportunity to manage its foreign exchange risk over time, the

long-term valuation effects are likely to be less severe than the short-term effects.

Alternatively, for firms in the left tail of the distribution (i.e., f inancially distressed firms) cur-

rency movements are more likelyto signif icantly affecttheir fundamental values. We hypothesize

The authors would like to thank Bill Christie (Editor), two anonymous referees,Andres Almazan, Warren Bailey,Sohnke

Bartram, Greg Brown, Alex Butler, Fang Cai, Ty Callahan, Katheryn Dewenter, Li Gan, Jane Ihrig, Stephen Magee,

Bernadette Minton, Sridhar Sundaram, Sheridan Titman,Hong Yan, and the participants at seminars at the University of

Texas at Austin,the FMA meetings, and the WFA meetings for helpful comments.

∗Kelsey D.Wei is an Assistant Professor in the Naveen Jindal School of Management at the University of Texas at Dallas

in Richardson,TX. Laura T. Starks is the CharlesE. and Sarah M. Seay Regents Chair in the McCombs School of Business

at the University of Texasat Austin in Austin, TX.

1Specifically, Bartram et al. (2010) find that pass-through activities and operational hedging may each reduce a firm’s

foreign exchange exposure by 10% to 15%, and that financial hedging may further reduce foreign exchange exposure by

40%.

Financial Management •Winter 2013 •pages 709 - 735

710 Financial Management rWinter 2013

this would occur due to the limited ability, or even inability, of these firms to access external

capital markets, hedge foreign exchange risks through operational or financial hedging, or to pass

through increased costs to their customers.

Specifically, although the average firm may be able to smooth out the effects of unfavorable

currency movements on cash flowsby accessing the external capital market, fi nanciallydistressed

firms would have more difficulty doing so because of their higher costs of capital.2Consequently,

these firms would face increased cash flow volatility. Moreover, this inability to raise money

externally would ultimately cause financially distressed firms to bypass attractive investment

opportunities (Campello, Graham, and Harvey, 2010). Thus, the direct cash floweffect of foreign

exchange movements is more likely to lead to an impact on the fundamental value of financially

distressed firms. Consistent with this argument, Eisdorfer (2007) shows that for financially

distressed firms, shocks to cash flows have a stronger impact on current stock prices than shocks

to discount rates.

Second, according to Minton and Schrand (1999), increased cash flow volatility may lead to

lower S&P bond ratings, higher yields to maturity, and lower analyst following. Thus, financially

distressed firms may have limited ability to hedge the foreign exchange risk in financial markets.

For example, a distressed firm would find it harder to hedge currency risk using foreign exchange

(FX) derivativesas hedging costs depend upon a f irm’s creditworthiness. Specifically, a firm with

a poor credit rating may have difficulty finding banks willing to enter into multiyear forward

contracts. As a result, it may have to resort to option contracts that would cost significantly

more (Schoenberger, 2011). Bergbrant and Hunter (2011) find that exchange rate exposure is

highly sensitiveto credit constraints. Further, financially distressed firms may also have difficulty

engaging in financial hedging through the issuance of foreign currency denominated debt due to

their higher default risk.3This increased difficulty of financial hedging implies that the f irm’s

fundamental value is more likely to be negatively affected by foreign exchange risk. Indeed,

in 2002, Xerox announced that its reduced credit rating prevented the firm from hedging the

currency risk of its foreign operations resulting in substantially larger losses than expected.

Third,operational hedging, such as moving plants overseas, lending internationally,or engaging

in foreign direct investment, may not be feasible for financially distressed firms as this distress

often leads to reduced investments. In addition, since these firms may have already started

to lose customers (Titman and Wessels, 1988; Molina and Preve, 2009b), they would have

fewer opportunities to pass through the negative effects of foreign exchange movements to their

customers.

Since financial distress prevents firms from effectively managing and reducing the effects of

exchange rate movements on firm value, we conjecture that firms that have greater probabilities

and costs of financial distress are likely to have greater exposure to exchange rate risk. Using

a sample of US manufacturing firms, we test this central hypothesis in several ways. We begin

by examining whether a simple correlation exists between a firm’s likelihood of default and

its foreign exchange exposure. Using default probabilities derived from Merton’s (1974) bond

pricing model, we find that firms that are more likely to enter into distress have greater absolute

foreign exchange exposure elasticities over the subsequent 36 months, controlling for market

returns and prevailing interest rates.

2For example, Atanasova (2007) and Molina and Preve (2009a) find that financially distressed f irms have to replace

financial debt and equity with more expensive sources of financing such as trade credit.

3Bartram et al. (2010) find that financial hedging with foreign cur rencydenominated debt appears to have an even larger

effect on foreign exchange exposure than the use of FX derivatives.