conditional on market returns. This approach allows us to compare our results with the
other key studies of exchange rate exposure, and it means that our gauge of exposure will
measure what Bodnar and Wong (2000) call “residual” exposure. As Bodnar and Wong
stress, estimating conditional exposure using the market return implicitly controls for many
of the variables other than exchange rates that affect returns. We include measures of both
local and world market returns. This makes the estimates both more stable and more
meaningful. Of course, it also means that the exposure measure excludes the local
market’s average sensitivity to the exchange rate, as it is reflected in the local market
return. To make sure that our findings are not driven by this aspect of our specification,
we also estimate exposure leaving out the local market return, and we report those
estimates in the Section IV.
Our treatment of the exchange rate itself differs somewhat from most of these other
studies, however, in that we use individual exchange rates, rather than a trade-weighted
exchange rate. In this regard, we take the same approach as do Dahlquist and Robertsson,
who use individual currencies to examine the exposure of hundreds of Swedish firms.5
Dahlquist and Robertsson emphasize that the exposure shows up more clearly when the
individual exchange rates are used. Furthermore, they argue convincingly that past studies
may have missed seeing foreign exchange exposure because it was masked by the
aggregation of trade-weighted indices. In our case, the use of individual currencies is also
supported by the fact that the currencies in the sample show enough independent variation
against the major exchange rates that we are able to distinguish differences in their
importance for firm returns.
5 Allayannis and Ofek (2001) also use individual exchange rates to check the robustness of their original results, which use a trade-weighted exchange rate.