The effects of exchange rate movements on non-financial UK firms

International Business Review 10 (2001) 51–69www.elsevier.com/locate/ibusrev

The effects of exchange rate movements onnon-financial UK firms

Katrina Bradley1, Peter Moles*

University of Edinburgh Management School, William Robertson Building, 50 George Square,Edinburgh EH8 9JY, UK

Received 20 December 1998; received in revised form 4 November 1999; accepted 5 July 2000

Abstract

This study examines the effects of direct and indirect economic currency exposure on agroup of publicly-listed, non-financial UK firms. Information was obtained from the companiesat two points in time, during a period of sterling depreciation and then one of appreciation,and the results compared. When sterling depreciated, firms experienced increased profit mar-gins and/or sales volumes and increases in the cost of foreign-sourced inputs. The oppositeconditions were reported for sterling appreciation. Our results show considerable stability inthe estimates of economic exposure between the two periods. In managing currency effects,about 75 per cent of exporting firms adjusted either margins or volumes, or both, in responseto changes in the exchange rate. As with other studies, we found a significant industry effect.Overall we find that the results confirm the impact of economic currency exposure but, at thesame time, firms are less exposed to exchange rate movements than the theory would suggest. 2001 Elsevier Science Ltd. All rights reserved.

Keywords:Economic exposure; Foreign exchange; Industry effects; Strategic risk management; Cur-rency risk

* Corresponding author. Tel.:+131-650-3795; fax:+131-668-3053.E-mail address:[email protected] (P. Moles).

1 The empirical work on this paper was carried out while Katrina Bradley (now at Bain & Company)was at the University of Edinburgh.

0969-5931/01/$ - see front matter 2001 Elsevier Science Ltd. All rights reserved.PII: S0969 -5931(00 )00041-X

52 K. Bradley, P. Moles / International Business Review 10 (2001) 51–69

1. Introduction

The economic exposure model, as developed by Duffy (1972), Shapiro (1975),Adler and Dumas (1984), Flood and Lessard (1986), Soenen and Madura (1991) andothers, considers the impact of exchange rate movements on firm value. Firms engag-ing in foreign trade will face timing effects in the payments and receipts of foreigncurrencies leading to transaction exposure. Additionally, firms with foreign oper-ations also face translation exposure when these are consolidated and notionally con-verted into the parent company’s currency. Economic currency exposure is a broaderconcept that includes both transaction and translation exposure effects but also takesaccount of changes in the relative competitive position of firms resulting from unan-ticipated currency movement (Pringle, 1991; Shapiro, 1992). The theory emphasisesthat it is the nature of the competitive environment in which the firm operates andthe type of products involved that determine firms’ sensitivity to exchange rate move-ments. Luehrman (1990) argues that exposure depends on demand shifts and howcompetitors react to currency movements. Hodder (1982) points out that even thosefirms with a purely domestic cost and revenue base but with foreign-domiciled com-petitors will be affected. So absence of foreign currency transactions does not auto-matically eliminate economic exposure. In addition, these domestic-only firms maybe indirectly affected by currency effects due to their suppliers sourcing abroad.

Flood and Lessard’s (1986) model for economic exposure takes into account bothcosts and revenues. They postulate that multinational corporations that both sourceand sell in competitive international markets will be less sensitive to changes inforeign exchange rates than those firms engaged solely in importing or exporting.Pringle and Connolly (1993) provide a model that distinguishes between directexposure, where changes in the exchange rate directly affect a firm’s costs and rev-enues, and indirect exposure, where the effect of exchange rate movements is a resultof its competitive position and, in particular, depends greatly on whether a firm hasinternational competitors. Moffet and Karlsen (1994) characterise economic exposurein terms of functional structure, in essence the degree of the firm’s internationaldiversification, and competitive environment, that is, the nature of the market inwhich the firm sells its output. This component is similar to the competitive effectrecognised by Flood and Lessard. As a result, firms may adopt a range of strategiesthat depend on the degree of competition. These range from passing on the exchangerate effect, by adjusting the foreign price so as to maintain the value in home currencyterms, by absorbing fluctuations through lower profit margins, or by combinationstrategies which seek to trade-off profitability and market share (Menon, 1995; Sund-aram & Black, 1992).

Research in this area has focused on the competitive situation of the firm and howunexpected movements in exchange rates affect the value of the firm. Most large-scale studies have used market-based variables, regressing the change in share priceagainst movements in an exchange rate or a trade-weighted index, to obtain a meas-ure of the sensitivity of firm value to currency movements (Amihud, 1994; Bartov,Bodnar & Kaul, 1996; Bodnar & Gentry, 1993; Donnelly & Sheehy, 1996; He &Ng, 1998; Jorion, 1990). As a result, strategic issues and potential differences in

53K. Bradley, P. Moles / International Business Review 10 (2001) 51–69

economic exposure between industries have been largely ignored. A major problemwith estimating sensitivities from changes in the firm’s share price due to currencychanges is that this will be a residual estimate, obtained after firms have undertakenhedging activities, and not indicative of the underlying exposure (Miller & Reuer,1998). As a consequence, the results of the studies cited above using share priceshave provided only mixed support for the effects of economic exposure.

In examining the exchange rate effects on firms, this study makes use of individualfirm’s own estimates of their exchange rate sensitivities rather than estimating theseindirectly from share prices. It also examines these sensitivities at two points in time,first following a prolonged period of sterling depreciation and then one of rapidappreciation, to determine the stability of the ratings. It also examines the extent towhich firms trade-off market share against profitability. We also provide evidenceon industry effects and the result of six in-depth, follow-up interviews.

The next section outlines the nature of our data. Section 3 examines the resultsof exchange rate movements in the three specific areas: the effects of sterling appreci-ation and depreciation, firms’ exchange rate sensitivities and the nature of the trade-off between sales volumes and profitability, and finally, industry effects. Section 4reports the results of the six case studies of firms that took part in the survey, whileSection 5 concludes the paper.

2. Data

The research is based on two postal questionnaire surveys about the nature of theforeign exchange exposure for UK non-financial companies, the first in March 1996and a follow-up in March 1997. The survey included all the exchange-listed UKnon-financial companies in the EXTEL Company Research Database as at November1995 (629 companies in total). The decision to examine only non-financial firms wasbased on the complexity of foreign currency exposures and risk-management pro-cesses used by financial firms and the prescriptions of the economic currencyexposure theory which treats firms as producers and consumers. Most empirical stud-ies have focused exclusively on multinational corporations where the degree of econ-omic exposure is likely to be significantly lower than the exposure of purelyexporting or importing firms due to the offsetting nature of their international cashflows (Batten, Mellor & Wan, 1993; Belk & Glaum, 1990; Choi & Prasad, 1995;He & Ng, 1998). Unlike previous surveys of corporate currency exposure, the ques-tionnaire was distributed to all companies in the survey population, regardless ofany prior determination of the extent of their international involvement. The studytherefore includes purely domestic companies that have no foreign currency trans-actions. This has enabled the indirect or competitive effects of economic exposureof such firms to be investigated. In addition, the research covers publicly-listed firmsin order to take advantage of the additional information available, such as industrialclassification, group sales, and other corporate information that could be obtainedoutwith the survey instrument. Information was sought on the effect of changes insterling, and the degree of sensitivity of firms’ costs, sales and profit margins. The


follow-up survey was prompted by the significant sterling appreciation that tookplace subsequent to the first survey. It was anticipated that the respondents wouldreport a higher degree of economic exposure in the follow-up survey due to the sizeand speed of sterling’s appreciation.

The usable response rate was 51 per cent for the first survey and 79 per centfor the follow-up. In order to test for non-response bias, known financial and othercharacteristics of the respondents versus non-respondents, as shown in Table 1, wereused to determine whether there were any significant differences.

In addition, comparison of the financial characteristics or the geographical break-down of turnover of respondents and non-respondents does not indicate any signifi-cant non-response bias. When five ‘super-large’ non-respondent firms which distortedthe data were removed, a two-tailedt-statistic could not reject the hypothesis thatthe two samples were the same. A detailed breakdown of the sample by the 32industry classifications showed that just two categories, tobacco and integrated oil,with one and three firms had no respondents. In the extractive industries group, sixout of seven firms responded. In the largest single industrial category, engineering,37 out of 66 firms returned the questionnaire.

Table 1Characteristics of respondents and non-respondents

Financial information Survey respondents Survey non- t-value (2-tailed test)2

(£000) respondents1 (£000)

Panel AAverage net assets 295,604 507,764Adjusted: 0.34 (p=0.736)

(265,858)Average turnover 710,208 1,224,659Adjusted: 20.46 (p=0.644)

(729,020)Average profit before tax 48,453 101,979Adjusted: 20.72 (p=0.470)

(56,036)Panel BPercentage average turnover: 67 68 20.02 (p=0.984)UKPercentage average turnover: 13 12 0.27 (p=0.785)Other ECPercentage average turnover: 20 20 20.16 (p=0.870)Rest of world

1Calculated for each company as the average of the financial data for 1991–1995 included in theExtel Company Research database. The comparison shows the results for all firms and excluding five‘super-large’ firms with turnover in excess of £10 billion from the sample. The net usable responserate was 51 per cent; the gross response rate was 68 per cent.2t-tests were computed using the adjusted figures from the survey. That is, removing the five ‘super-large’ firms from the analysis.


3. Effects of exchange rate movements

If economic exposures are symmetrical, we can expect to see opposing resultsfrom periods of sterling appreciation and depreciation on corporate cash flows andprofitability. Firms that are disadvantaged in periods of sterling depreciation, i.e.importer firms with more costs denominated in foreign currencies than revenues,will benefit from currency appreciation. We first examine the impact on firms fromthe directional movements in the exchange rate before examining firms’ sensitivityand hence exposure to currency movements. In particular, we wanted to test thehypothesis that indirect economic exposure effects were an important element ofexposure. Finally, we also examine firms by industry sector to determine whetherthere are significant differences in economic exposure that reflect firms’ market pos-ition.

In our research instrument, we make use of three economic exposure effects onUK firms. First, the direct currency effect of reduced export revenues and increasedimport costs, although the immediate impact may be deferred due to earlier currencyhedging. Second, the indirect effect of the improved relative position of competitorsin countries with weaker currencies, thus enabling them to discount prices in theUK market. The opposite effect applies to competitors in countries with strongercurrencies. Third, the indirect effect from the firm’s exposed customers and suppliersto similar price pressures. Finally, we examine industry effects. On the whole wefind that our sample has less economic exposure than predicted by the theoreticalmodels and that significant industry differences exist.

3.1. Appreciation and depreciation of sterling

A change in the external value of sterling either decreases (in the case ofappreciation) or increases (in the case of depreciation) the amount of home currencya UK company receives for a unit of foreign currency. As hypothesised by Walker(1986), this affects the cash flows of British companies that source inputs or selltheir products abroad as a result of changes in foreign demand and profit margins.For firms with significant foreign sales (i.e. exporters), sterling depreciation shouldraise sales volumes and/or increase margins whereas those firms with significantforeign inputs (that is, importers) should experience reduced sales volumes and/orprofit margins. An appreciation in sterling should have the opposite effects.

Table 2 shows the result derived from the 1996 survey. Of the responses, 60 percent reported an increase in the cost of foreign-sourced inputs as a result of sterlingweakness. In contrast, only 35 per cent indicated that sterling depreciation hadincreased export volumes and 33 per cent saw an improvement in profit margins.Only a small number of companies reported indirect competitive effects with 12 percent indicating that domestic sales had improved as a result, while 7 per cent reportedhigher profit margins.

Table 3 reports on the 1997 follow-up survey that took place in a period of signifi-cant sterling appreciation. The most widespread effect reported by 64 per cent ofthe sample was a reduction in the cost of foreign-sourced inputs. A further 11 per


Table 2The effects of sterling weakness (1996 survey)

Economic exposure effect Yes (%) No (%) Not applicable(%)

Direct1. Increased costs of foreign sourced inputs 60 17 232. Increased sales volumes in export markets 35 34 313. Increased profit margins on export sales 33 36 324. Increased debt servicing costs 31 32 37Indirect5. Increased sales volumes in domestic market 12 53 356. Increased profit margins in domestic market 7 60 33

% of companies (N=298).Note: data refer to the percentage of respondents’ answers given in each category to the six questionsabout the nature of their foreign currency exposure. Respondents were asked to indicate whether theircompany had experienced any of the above effects as a result of the weakening of sterling relative toother major currencies.

Table 3The effects of sterling appreciation (1997 survey)

Economic exposure effect Yes (%) No (%) Not applicable(%)

Direct1. Reduced costs of foreign sourced inputs 64 19 172. Reduced sales volumes in export markets 27 44 293. Reduced profit margins on export sales 46 27 274. Reduced debt servicing costs 39 24 375. Reduced sales volumes in domestic market 11 74 15Indirect6. Reduced profit margins in domestic market 16 68 167. Reduced costs of domestic sourced inputs 11 77 12

% of companies (N=209).Note: data refer to the percentage of respondents’ answers given in each category to the six questionsabout the nature of their foreign currency exposure. Respondents were asked to indicate whether theircompany had experienced any of the above effects as a result of the strengthening of sterling relativeto other major currencies.

cent reported indirect currency effects in that their company had also experienced areduction in the cost of inputs sourced in the domestic market. The effect on theforeign sales volume and margin for exporters was mixed. Only 27 per cent reporteda drop in volume but 46 per cent reported reduced profit margins. For those firmscompeting domestically and experiencing indirect effects, 11 per cent reported adecline in domestic sales volumes whilst 16 per cent had encountered a reductionin margins. Overall, the results show that firms are more sensitive to exchange rateeffects on their costs than their revenues.


A key question is whether the effects of sterling depreciation and appreciationwere the same. Table 4 combines the two surveys. It was anticipated that a largerproportion would report exchange rate effects in the second survey. The scale andspeed of sterling appreciation in 1997 together with the significant national presscoverage made it more likely that respondents would be more aware of the impactof sterling’s appreciation on their companies.

Contrary to our expectations, the results show that most of the exchange rateeffects were the same in the 1997 survey. One of the most significant changesbetween the two surveys is the proportion of firms that had experienced a changein export profit margins. In 1996, 33 per cent had reported an increase in marginfollowing sterling depreciation, whereas in 1997, the proportion of respondentsreporting a reduction in export margins as a result of sterling appreciation was sig-nificantly higher at 46 per cent, indicating an asymmetric currency effect. The resultssuggest that respondent firms were more exposed to the adverse effects of appreci-

Table 4Comparison of the effects of sterling appreciation and depreciation (figures as %)

Effect 1996 Survey 1997 Survey(Increased costs, (Decreased costs,margins and margins andvolumes) (N=298) volumes) (N=209)

1. Costs of foreign sourced inputsYes 60 64No/Not applicable 40 36McNemar statistic=0.3782. Sales volumes in export marketsYes 35 27No/Not applicable 65 73McNemar statistic=5.225*3. Profit margins on export salesYes 33 46No/Not applicable 67 54McNemar statistic=14.841**4. Debt servicing costsYes 31 39No/Not applicable 69 61McNemar statistic=5.891*5. Sales volumes in domestic marketYes 12 11No/Not applicable 88 89McNemar statistic=1.0916. Profit margins in domestic marketYes 7 16No/Not applicable 93 84McNemar statistic=7.314**

**Significant at 0.01 level.*Significant at 0.05 level.


ation and less able to benefit from depreciation. In this case, the exchange rate impacton firms is at odds with the results from other questions. One possible explanationis provided by the model developed by Froot and Klemperer (1989) where firms’response in a competitive environment where market share matters is predicated onthe future expected behaviour of the currency. Prior to the second survey, sterling’srapid appreciation had followed a number of years of sustained depreciation andmanagers might have expected the currency to revert to trend. In this situation, pre-serving long-term market position at the expense of short-term profit margins wouldgo some way to explaining the difference in response.

Given the change in the exchange rate between the two surveys, we could antici-pate that firms reporting increases in the initial survey when sterling depreciatedwould, in the follow-on survey, report decreases as a result of sterling’s appreciation.A measure of the significance of differences in matched pairs of observations, wherethe data are measured on an ordinal scale, can be obtained from the McNemar changetest. The test is particularly suitable when determining the significance of anyobserved change in responses where the first response is obtained before and thesecond after an event or change has taken place and where each subject is used asits own control. The McNemar statistic thus determines whether there is a significantswitch in responses as a result of the changes in exchange rate behaviour betweenthe surveys. For the profit margin on export sales, the McNemar test reveals thatthis is statistically significant at the 0.01 level. For those firms suffering the indirecteffects from foreign competition, the profit margins for domestic sales were alsosignificant at the 0.01 level. The test results for sales volumes and debt servicingcosts were significant at the 0.05 level. The statistics for the cost effects of foreign-sourced inputs and the indirect impact for domestic market sales volumes were insig-nificant.

We interpret this divergence between the currency effects on volumes and profitmargins as a result of firms acting strategically to protect market share by acceptingreduced margins. This accords with the findings of other research, such as Belk andGlaum (1990) and Luehrman (1990). Our first survey was undertaken after a sus-tained period of sterling weakness following Britain’s departure from the exchangerate mechanism in 1992. The rapid appreciation in sterling that occurred betweenthe first and second surveys had persisted for approximately 6 months. Our resultsshow that the initial impact of sterling appreciation is on profit margins, as companiesattempt to protect their market share, possibly in the expectation of a subsequentreversal in sterling’s external value. It is also possible that the effect on sales volumesis a longer-term effect not fully captured by the responses to the second survey.

Another possible, non-mutually exclusive, explanation is that inputs are largelycommodities trading on price in international markets whilst firms’ sales are differen-tiated. Sundaram and Mishra (1990) propose that the ability to pass on currencyeffects to customers will depend on the price elasticity of customer demand, whichin turn depends on product differentiation. We tested this proposition by relating oursurvey results for costs, sales volume and profit margin to firms’ differentiationscores obtained from the survey. We applied Goodman and Kruskal’s gamma testbecause of its suitability for ordinal data. It also provides information on both the


strength and the direction of the relationship between the two variables. We obtaineda result of 0.1430 for costs, 0.2087 for sales volumes, and 0.1894 for profit margins.These results are significant for costs at the 0.05 level and 0.01 for sales volumesand profit margins. The sign is positive, not negative, indicating that firms withdifferentiated products are more sensitive to exchange rate effects than undifferen-tiated producers or consumers. Although these results are hard to interpret, we areinclined to the view that the differences in firms’ input and output sensitivities arenot due to differentiation effects.

The results of the two surveys discussed above provide a degree of empiricalsupport for the effects of economic exposure on non-financial British firms. Theyindicate that a significant change in sterling’s external value can affect not only thecosts and revenues of firms engaged directly in international trade but also thoseoperating solely within the UK. They also indicate that firms adopt a strategicresponse to currency movements.

3.2. Exchange rate sensitivity

Respondents were asked to rank the exchange rate sensitivity of sales volumes,profit margins and costs on a five-point scale, with ‘1’ being ‘highly insensitive’ and‘5’ ‘highly sensitive’. Fig. 1 shows the responses for cost sensitivities. These resultsreveal that 55 per cent of respondents ranked costs as being relatively insensitive toexchange rate movements. Our sample of firms consists of relatively large listedcompanies in areas such as brewing, building and construction, engineering, elec-tronic and electrical equipment, household goods, leisure and hotels, paper packingand printing, and retailers—in all, 31 different industrial sectors. The results indicatethat the majority of such firms consider they are relatively insensitive to exchange

Fig. 1. Exchange rate sensitivity for costs.


rate movements. It is of course possible that there are few large UK firms withhigh levels of economic currency exposure, but this is contrary to the geographicalbreakdown of activity. On average, one-third of turnover of our sample was derivedfrom overseas sales with the European Union representing 13 per cent and the restof the world 20 per cent. However, our results are consistent with Miller and Reuer(1998) when examining US multinationals. Using multivariate econometric methods,they found that, depending on the model, only 13 to 17 per cent of their sample hada significant exposure (at the 0.05 level) to foreign exchange movements.

These results are somewhat surprising given that 87 per cent indicated that theysold some or all of their product abroad and 90 per cent indicated that they sourcedsome of their inputs in foreign markets. In contrast, 18 per cent indicated that theircompanies were relatively sensitive. In this case, 7 of the 16 respondents who indi-cated an exchange rate sensitivity of 5 were from companies that sourced 20 percent or less of their inputs in foreign markets. This suggests that such firms aresubject to the indirect effects of economic currency exposure.

Fig. 2 shows respondents’ rating for profit margins and sales volumes. The firstpoint to note is that a substantial majority (64 per cent) indicated that their compa-nies’ sales were relatively or highly insensitive to foreign exchange movements (ascore of ‘1’ or ‘2’). The results were somewhat lower for profit margins since 51per cent indicated their companies’ margins were relatively or highly insensitive.Only 12 per cent of firms indicated that sales were relatively or highly sensitive toexchange rate movements, the number doubling when profit margins were involved.This is a surprising result.

There is a question as to how well specified these results are. The follow-up surveyalso asked respondents to rate the exchange rate sensitivity of sales volumes, profit

Fig. 2. Exchange rate sensitivity for profit margins and sales volumes.


Table 5The sensitivity of cash flows to exchange rate movements

Sensitivity rating Costs (%) Profit margins (%) Sales volumes (%)

19961 19972 19961 19972 19961 19972

1 (Highly 31 25 26 24 38 35insensitive)2 24 31 25 25 26 283 27 30 25 28 24 254 13 12 18 17 9 105 (Highly sensitive) 5 2 6 6 3 2Wilcoxon matched 20.3037 (p=0.761) 21.089 (p=0.276) 20.1048 (p=0.917)pairs test statistic(2-tailedprobability)

1Number of respondents for each of the three categories=298.2Number of respondents for each of the three categories=209.

margins and costs. It was anticipated that there would be an increase in the proportionof answers reporting significant or highly sensitive effects based on the impact ofsterling’s rapid appreciation. The results by category of exposure and rating are givenin Table 5. The table shows that the responses from both surveys are very similar.We applied a Wilcoxon signed test to the two surveys to determine the extent towhich the results were the same. The test also takes into account the size of anydifference between the two sensitivity ratings given by each respondent. The statisticindicates that the sensitivity ratings given by finance directors in both surveys arethe same. This is borne out by the comparison of the ratings in the surveys givenin Table 6. This shows that approximately half the respondents to the follow-upsurvey gave the same sensitivity rating in both surveys. An additional third of respon-dents altered their sensitivity ratings by only one rating point. These results thereforesuggest that the sensitivity ratings given by most of the survey respondents representrelatively consistent assessments of the exchange rate sensitivity for their firms.

Table 6Changes in individual sensitivity ratings (N=209)

Sensitivity ratings Similarity of individual responses

Unchanged Changed by 1 rating Changed by.1 ratingpoint point

Sales volumes 102 (49%) 69 (33%) 38 (18%)Profit margins 111 (54%) 68 (33%) 28 (13%)Costs 109 (52%) 63 (30%) 37 (18%)


3.3. Profit margin versus sales volume trade-off

The data indicate that the profit margins of responding companies are more sensi-tive to exchange rate movements than sales volumes. In the 1996 survey, 24 percent of responses gave a profit margin sensitivity rating of either 4 or 5, whereasonly 12 per cent gave these ratings to sales volumes. There are a number of possibleexplanations for these differences. First, changes in profit margins are the end resultof market conditions. In addition, changes in volumes may be attributed to otherfactors in the marketplace rather than to movements in exchange rates. Finally,exporting companies face a choice between maintaining margins by holding the priceconstant in home currency terms, or reducing the price in home currency terms inorder to protect their foreign market share.

In the follow-up questionnaire, exporting firms were asked to detail their pricingand margin responses to sterling’s appreciation. These are given in Table 7 and showthat nearly 70 per cent of exporters fully or partially accept changes to their marginsas a result of the effects of currency appreciation. The most widespread responsegiven by 45 per cent of firms was to partially reduce the prices of exported goodsin sterling terms. A further 19 per cent indicated that their companies fully reducedthe sterling price to take account of currency appreciation. These results indicatethat exporting firms adopted flexible strategies in response to exchange rate changesalthough it is important to remember that the upward trend in sterling had onlyexisted for less than a year prior to the distribution of the survey. It should be notedthat these results contrast with Williamson (1990), who took the view that Britishfirms have a tendency to pass-on exchange rate changes to their customers, but theyare consistent with the findings of Luehrman (1990) for the US steel and auto indus-tries.

The short period of sterling appreciation prior to the follow-up survey may alsobe a possible reason for the relatively small proportion of respondents that ratedtheir sales volumes and profit margins as being highly sensitive to foreign exchangerates. Those firms that adjust their foreign currency prices to maintain a constantmargin following an appreciation in sterling may rate their profit margins as beinginsensitive to changes in exchange rates. Similarly, those companies that reduce theirprofit margins to preserve market share may perceive their sales volumes as beingrelatively insensitive. To test this hypothesis, the relationship between pricing adjust-ments and exchange rate sensitivity ratings of exporting firms was examined. How-

Table 7Margin and pricing responses to sterling appreciation (N=130)

Reaction % of Exporters

Maintain constant sterling prices 31Reduce sterling prices to the full extent of the appreciation 19Partly reduce sterling prices 45Combination of the above strategies 5


ever, no significant relationship was found between the pricing strategies of exportersand their exchange rate sensitivity ratings for sales volumes and profit margins. Thiswould indicate that the ratings represent the sensitivity of volumes and marginsbefore any pricing adjustments are made. There is evidence to support this, in that,of the seven responses from exporting firms that rated their sales volumes as highlysensitive, six indicated that they had fully or partially reduced their profit marginsfollowing sterling’s appreciation.

3.4. Industry effects

Moffet and Karlsen’s (1994) model proposes that economic currency exposure isa function of the competitive environment. Bodnar and Gentry (1993), in examiningUS, Canadian and Japanese firms, found that there were substantial differences inexchange rate sensitivities between industries. He and Ng (1998) reported that theforeign exposure of their sample companies was mainly concentrated in three sectors,electrical equipment, precision machinery and transport. This section looks at theextent to which variations in exchange rate sensitivity can be explained by industrymembership. The assumption is that companies within a particular industrial group-ing share a similar competitive position and, in particular, are largely involved inimporting, exporting, or competing domestically with foreign-based competitors tothe same extent.

Firms in the survey were classified into five sectors: utilities, services, consumergoods, general industrials, and mineral extraction. The results are given in Table 8and show that there is considerable variation in sensitivity ratings across industries.A non-parametric test, the Kruskal–Wallis one-way analysis of variance by ranks test,was used to determine whether the sensitivity ratings of the sectors were significantlydifferent. The test indicated that the ratings between the five sectors are all differentat the 0.01 level. The significant variability across industries indicates, as otherresearchers have pointed out, the importance of analysis at the market and firm-specific level, rather than aggregating all firms.

As might be expected, of the five groups, the utilities sector appears to be theleast sensitive to currency movements. Companies in the services sector also categor-ise their inputs and outputs as being relatively insensitive to exchange rate move-ments. This finding accords with the view of Bodnar and Gentry (1993) that pro-ducers of non-traded goods are less likely to experience economic currency exposure.While there is considerable variation in ratings given by respondents from the con-sumer goods sector, their costs appear to be exchange rate-sensitive. About 40 percent of these respondents gave a sensitivity rating of ‘4’ or ‘5’. In particular, thosefirms in the spirits, wines and ciders, food producing, and household goods industriesall have a high proportion of respondents with costs that are sensitive to foreignexchange rates. Companies in the minerals extraction sector reported low sales vol-ume sensitivity but that profit margins were highly sensitive. This can be explainedby their selling into a world market where prices are determined globally and hencenot sensitive to changes in sterling, but this then forces them to absorb exchangerate fluctuations via their profit margins.


Table 8Exchange rate sensitivity ratings by industry

Sensitivity ratings n 1 2 3 4 5highly highlyinsensitive sensitive(%) (%) (%) (%) (%)

CostsAll companies 292 31 24 27 13 5Utilities 15 67 20 2 13 –Services 112 48 22 17 10 3Consumer goods 35 20 11 31 29 9General industrials 116 14 29 39 13 5Mineral extraction 14 21 21 22 7 29KW=40.13 (significant at 0.01 level)Sales volumesAll companies 292 38 26 24 9 3Utilities 15 73 20 7 – –Services 112 49 26 17 6 2Consumer goods 35 34 40 23 – 3General industrials 116 21 22 38 16 3Mineral extraction 14 57 29 – 7 7KW=40.34 (significant at 0.01 level)Profit marginsAll companies 292 26 25 25 18 6Utilities 15 60 26 7 7 –Services 112 38 27 19 12 4Consumer goods 35 11 37 26 17 9General industrials 116 15 21 32 25 7Mineral extraction 14 7 14 43 14 22KW=37.09 (significant at 0.01 level)

KW is the Kruskal–Wallis one-way analysis of variance by ranks test.The sensitivity ratings represent the responses to the first survey, distributed in March 1996.

Even though there are significant differences in the exchange rate sensitivity rat-ings between the five sectors, there is also considerable variation within the sectors.Miller and Reuer (1998) point out that this is because companies within a particularindustry may vary greatly with one another depending on their choice of strategies.These differences reflect divergences in the extent to which they source or sell inforeign markets, the degree of product differentiation achieved, or the degree of pricesensitivity of demand for their products and services. Our results substantiate thisobservation since it is clear that even those companies that belong to the same indus-try group exhibit substantial differences in the magnitude of their economic cur-rency exposure.


4. Case studies

Six firms that had responded to the survey agreed to participate in follow-up casestudies. By probing behind the survey data, we were able to obtain a number ofimportant insights into the sources of exchange rate sensitivity for these firms, whichpartially validate our survey results, although the small number of firms involvedmeans that the results cannot be regarded as representative of the survey population.All the companies sell at least some of their products in foreign markets, althoughthe proportions ranged from 5 to 85 per cent of total sales.

Table 9 compares the firms’ survey responses and categorises them according tothe Flood and Lessard (1986) model’s exposure types (these are exporter, importer,local market, and world market). Company A has low input cost sensitivity and highoutput sensitivity giving it the sensitivities of an ‘exporter’; company B has theopposite, making it an ‘importer’. These results were then probed in the interviewsand the revised classifications are given in column four. The results are generallyconsistent with the assigned position derived from the surveys. Companies E and Fhighlight one problem in reducing a firm’s estimated sensitivity to a single numbercovering all its activities: the interviews revealed that different product lines had

Table 9The economic currency exposure profiles of the sample firms

Company Exchange rate sensitivity ratings1 Economic Economicexposure profile exposure profilebased on the based on thesurvey data interview

evidence

Costs Margins Volumes

A 2.5 5 5 Exporter ExporterB 4 2 2 Importer ExporterC 5 5 5 World Market World MarketD 4 2 2 Importer ImporterE 2.5 4 4 Exporter Exporter

(woollenapparel)World Market(cashmereapparel)

F 3 4 4 World Market World Market(aerospacesealants)Exporter(chemicals)

1A five-point scale was used, ‘1’ being highly insensitive.Where a respondent estimated different sensitivity ratings in the 1996 and 1997 postal surveys, anaverage of the two ratings is presented.


different sensitivities. Company E was defined from the survey as an exporter(significant income sensitivity and low cost sensitivity). The case study revealed thatE, in the textile and apparel industry, has two different exposure profiles, exporterand world market depending on product specification and its intended market. Simi-larly, F is defined as world market from the survey. However, the detailed discussionrevealed that its two main divisions have very different economic exposure profiles,one being world market, the other exporter. Although the survey data aggregated allthese firms’ divisional and product sensitivities into one variable, the results do cap-ture at least part of these multi-product and divisional firms’ exposures.

Company B, defined as an importer on the basis of the survey results, revealedthe sensitivity profile of an exporter. The company sources entirely in world com-modity markets in US dollars and sells in the domestic market in sterling. However,the interview revealed a subtle set of conditions due to the considerable import pen-etration of the domestic market and the largely commoditised nature of its productand that of its competitors. When sterling rose against other currencies, its majorEuropean-based competitors, with costs denominated in local currencies, were ableto undercut B’s prices. The firm considered this indirect exposure from competitorswith costs in European currencies to be more significant than the positive impact ofsterling appreciation on its dollar-denominated costs.

With the exception of company B, we are able to conclude that the survey infor-mation is an accurate method of measuring the direct economic exposure of firms.To fully capture the differences in multi-business firms, as evidenced by E and F,requires divisional, if not product line, assessment of individual exposures. In thecase of company B, the survey data fail to capture the importance of indirect econ-omic exposure arising from competitive effects.

The case studies highlight the complexity involved in determining the exact natureof economic exposure for firms. It revealed that the impact depends not only on theextent to which a firm sells its products in and sources its inputs from foreign mar-kets, but also on factors such as the location of its major competitors and the pricesensitivity of customers. While it is difficult to generalise about the factors whichcause the cash flows of firms to be highly sensitive to exchange rate effects, thecomparison of the currency exposure profiles of the case studies and the evidencefrom the surveys suggests that the questionnaires provide a relatively accuratemethod of measuring economic exposure.

5. Conclusions

This paper makes use of survey data to determine the degree to which non-finan-cial UK firms are exposed to currency effects, as well as examining specific contribu-tory factors discussed within the literature. The advantages of the approach are thatit enables a representative cross-section of firms to be included in the data set anda range of replies can be generated. The weaknesses, as the case study illustrated,are that the estimates are aggregates of specific line of business, or even product,sensitivities and hence are imprecise. Respondents were also presented with a set of


alternatives that may be difficult to relate to their specific situation. Nevertheless,within these limitations, the survey method does permit us to explore the importantinteractions between firms’ behaviour and changes in the exchange rate.

According to the theory of economic exposure, movements in exchange rates canaffect the future cash flows of almost all types of firms whether involved directlyin cross-border transactions or not. Within the limitations of our methodology, ourfindings for UK companies provide empirical support for the positive and negativeeffects of economic currency exposure. The results indicate that the direct impactof exchange rate movements affects firms’ sales volumes or profit margins, or both,and input costs. The findings are also consistent with the notion that exchange ratemovements lead to the indirect, competitive effects as proposed in the Shapiro (1992)and Pringle and Connolly (1993) models. We find that respondents in those firmsinvolved in servicing the domestic market reported changes in demand and costs asa result of changes in the exchange rate.

Another significant finding is that UK firms appear to be taking a longer-term,strategic view of the effects of currency fluctuations. A large number of respondentsindicated that the sterling appreciation, which took place prior to the follow-up sur-vey, was being absorbed by companies reducing their profit margins in order toprotect market share.

In contrast to the stance taken in some of the theoretical literature, the resultsindicate that UK companies may benefit from changes in exchange rates. Forexample, approximately two-thirds of the respondents in the follow-up survey indi-cated that their company had experienced a decline in costs of foreign-sourced inputsfollowing sterling’s appreciation.

While the research provides support for the effects of economic exposure, it is toa lesser extent than the theory would suggest. When asked to rate the exchange ratesensitivity of sales volumes, profit margins and costs, more than half the respondentsranked these as being insensitive, that is, either ‘1’ or ‘2’. This is surprising in thatonly 15 per cent of the responding companies can be regarded as purely domesticin the sense that they do not source or sell in foreign markets. There exists, however,a small proportion of respondents who indicated that cash flows were highly sensitiveto exchange rates (5 per cent for costs, 3 per cent for sales volumes and 6 per centfor profit margins). Our case studies also revealed some of the complexities in pro-viding a taxonomy of economic exposure. These emphasised the importance of firms’strategies, pricing policies and product mix as contributors. This suggests that futureresearch needs to examine these factors through more sophisticated evaluation tech-niques in order to identify firms with high and low levels of economic exposure.Further work using the case study methodology suggests one potential avenue. Thereis also scope for combining our survey methodology with econometric techniques,such as that of Jorion (1990), Donnelly and Sheehy (1996), and Miller and Reuer(1998).

Finally, how can the low sensitivities found in our research be reconciled withthe theory of economic exposure which suggests that changes in exchange ratesdirectly or indirectly affect the cash flows of most firms? One explanation is thatmany of these quoted firms are, in effect, multinational corporations with both sales


and costs arising in foreign currencies. Flood and Lessard’s (1986) model indicatesthat such firms achieve a natural hedge by having matching input and output sensi-tivities. Another possible explanation is that respondent firms may be unaware ofthe effects of currency movements on the firm’s cash flows. However, if this werethe case, the rapid appreciation in sterling between the two surveys should havesignificantly changed the responses, which was not the case.

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The effects of exchange rate movements on non-financial UK firms

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