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Foreign Exchange Exposure and Short-Term Cash Flow Sensitivity

In this paper we hypothesize that because of firms' ability to adjust to exchange rate movements over the longer term, stock prices are unlikely to reflect foreign exchange exposure unless a firm is particularly sensitive to short-term cash flow variability. Controlling for firms' ability to adjust their cost structures, we find that the magnitude of exchange rate exposure of U.S. manufacturing firms is related to firms' short-term leverage, availability of internal funds, size, costs of underinvestment and product specialization. Further, during large, unexpected movements of the dollar, firms with higher expected costs of financial distress show larger exposures as measured by their larger abnormal returns and abnormal volatilities in response to exchange rate shocks.