Foreign Exchange Exposure Method

Int. Fin. Markets, Inst. and Money 15 (2005) 125–140

A note on common methods used to estimate foreign

exchange exposure

Anna D. Martina,∗ , Laurence J. Mauerb,1

a

Department of Finance, Dolan School of Business, Fairfield University, Fairfield, CT 06824, USA

b Department of Economics and Finance, Tobin College of Business, St. John’s University,

Jamaica, NY 11439, USA

Received 17 May 2003; accepted 15 March 2004

Abstract

Understanding the impact of foreign exchange risk is a critical element for purposes of firm valuation and risk management. In this study, we review the benefits of capital market and cash flow

foreign exchange exposure estimation methods, and using a sample of large U.S. banks, we conduct a

comparison of the frequency with which each method detects exposure. We find some evidence of the

relative strength of the capital market-based method in expectations formation, since about 25% of

the sample that does not show significant cash flow sensitivity to the pound has significant stock price

sensitivity. We also find evidence of the relative strength of cash flows to detect exposure. Across all

five currencies examined, when cash flows have exposure, the capital market regularly (70–100% of

the time) does not find the exposure to be significant.

© 2004 Elsevier B.V. All rights reserved.

JEL classification: F31; C13

Keywords: Exchange rate exposure; Methods

∗

1

Corresponding author. Tel.: +1 203 254 4000x2881; fax: +1 203 254 4105.

E-mail addresses: amartin@mail.fairfield.edu (A.D. Martin), mauerl@stjohns.edu (L.J. Mauer).

Tel.: +1 718 990 6419; fax: +1 718 990 1868.

1042-4431/$ – see front matter © 2004 Elsevier B.V. All rights reserved.

doi:10.1016/j.intfin.2004.03.003

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A.D. Martin, L.J. Mauer / Int. Fin. Markets, Inst. and Money 15 (2005) 125–140

1. Introduction

Since exchange rate risk can affect cash flows and stock prices of firms, the exposure to

this risk is a key concern for investors, analysts, and managers....