The Relation between Exchange Rate Volatility and Firm Valuation: Polynomial Distributed Lag Model

This paper studies the sensitivity of cash flows generated by Taiwanese firms to changes in a trade-weighted index, as well as against the currencies of Taiwan's major trading partners. A traditional methodology, the capital market approach, typically found low or negligible levels of exposure for most firms. Moreover, this approach could not determine long-term exchange risks. We adopt the polynomial distributed lag model to examine the relative importance of economic versus transaction exposure by decomposing exposure into short-term and long-term components. Comparing this with the capital market approach, we find some evidence of the relative ability of cash flows to detect exposure. Our findings indicate that exporting firms show less significant net exposures to the U.S. dollar than to the Korean Won, and that importing firms show less significant net exposures to the Japanese Yen than to the Hong Kong dollar.