The Effect of International Currencies upon U.S. Stock Prices

Article excerpt

ABSTRACT

Over they ears, the literature has demonstrated that the earnings of many non-US companies have been sensitive to the US dollar. Since earnings are a prime determinant of stock prices, then stock prices are also currency sensitive. All firms are exposed to foreign currency risk in today's global economy. This study takes an opposite approach to the literature and investigates the association between eight non-US currencies and US stock prices as reflected by the Dow Jones Industrial Average and the Standard and Poor's 500 Stock Index.

The results show that even though various currencies exhibit significant relationships with stock prices at times, the impact is limited. These findings suggest that many firms take an active stance in managing their currency risks.. The results also demonstrate the changing relationships of paired currencies used in this study. Positive relationships were expected when paring currencies by region. For example, one would expect the European currencies (Euro, Pound, and SSFranc) or the Asia Pacific currencies (Yen, Sing$, and Rupee) would be positively related to each other in the same region over the time periods used and this was not the case during this investigation.

INTRODUCTION

The introduction of the euro in 1999 brought to the forefront the active research area of currency rate sensitivity. Early euro proponents foresaw the possibility of capital market integration that would bring a group of fragmented currencies together into a giant market of simple, less risky, cross-border transactions. The euro's initial fall and subsequent rise since its introduction along with fluctuating currencies of those countries that did not join the union has been the catalyst for the interest. There has clearly been a structural change in the financial markets as was expected.

Some companies take an active stance in managing their currency risks by using some sort of financial hedge. On the other hand, many companies chose not to hedge or to hedge only some currencies. These companies are looking for diversification benefits of being exposed to foreign currencies. Intuitively, currency movements should even out over the long run.

In today's global economy, all firms are exposed to foreign currency risk whether in an accounting or economic sense. Exchange rate changes are thought by many to be a major source of financial uncertainty since currencies influence a firm's asset and liability values, as well as profitability. In turn, profitability affects cash flows and stock prices for those firms that have not adopted or taken an active stance in managing currency risks.

A particular exchange rate regime also affects the behavior of all economic variables which, in turn, leads to uncertainty across all stock markets. Investors seek the highest return with the lowest risk and when investing in foreign countries, they face currency risk. Recent literature has concentrated on how the euro or other non-US currencies affect respective foreign markets. Taking an opposite view, this study investigates the effect of eight foreign currencies, one of which is the euro, upon US stock prices. Results will provide insight towards possible higher returns for investors as well as international portfolio risk aversion.

LITERATURE REVIEW

A review of the literature indicates that there has been considerable research seeking significant relationships between currency rates and stock returns. These interactions cover domestic markets (Jorion, 1990), international (Friberg & Nydahl, 1999), and emerging markets (Vaziri, 2003; Beer & Vaziri, 2004).

Early empirical currency research by (Adler & Dumas, 1984; Jorion, 1990) focused on the individual company's currency exposure by observing changes between a firm's price change and the US dollar. They found that the concept of exposure is arbitrary in the sense that stock prices and exchange rates are determined jointly. …