Exchange rate and interest rate exposure of UK non-financial firms and industries

Exchange rate and interest rate risk have been documented as the most managed financial risks by most UK non-financial firms and industries. This is probably because of the severe adverse effects that contrary movements in these financial risks can have on the value of the firm or industry. Nevertheless, empirical studies on these risks have been very few and predominantly limited in scope. Therefore, using a sample of 402 UK non-financial firms from 31 industries, over the period January 1990 to December 2006, this study examines the relevance of these financial risks on the stock returns of firms and industries. Following the weaknesses of the Ordinary Least Square (OLS) methodology, the AR(I)EGARCH-M model was subsequently used for the estimation. The results indicated that the stock returns of UK firms and industries were more affected by long-term interest rate risk than exchange rate risk (Trade weighted index, US$/£ JP¥/£, ECU/£ and Euro/£) or even short-term interest rate risk. Furthermore, the introduction of the euro reduced the exchange rate exposure and interest rate exposure of only a few UK firms and industries. Additionally, by means of the Herfindahl index as a measure of industry concentration, competitive industries were found to exhibit a higher degree of exposure to movements in exchange rates and interest rates, and also higher volatility in returns than industries that were classified as concentrated. Then using firm specific accounting variables, the results indicated that the determinants of exchange rate exposure were different to that of interest rate exposure. Finally, it was also found that for most UK firms and industries: increased risk did not necessarily lead to an increase in returns; severe adverse movements in exchange rates and interest rates can potentially make returns more volatile; volatility of returns has time varying properties; persistence of volatility is much higher in some firms and industries than others; and the volatility of returns increased in the period after the introduction of the euro