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Umeå School of Business and Economics Department of Accounting and Finance Master Thesis, Spring 2007

Supervisor: Anneli Linde Authors: Shudzeka Basile N.

Kum Hyceinth Njuh

Foreign Exchange Exposure of a Selected Number of Swedish

Multinational Firms: The Capital Market Approach.

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Table of Contents

Chapter 1: Introduction

6

1.1 Problem Background 6

1.2 Research Questions 8

1.3 Research Objectives 8

1.4 Limitations and Demarcation 8

1.5 Disposition 9

Chapter 2: Literature Review and Conceptual Framework

10

2.1 Conceptual Framework 10

2.1.1 Overview of Foreign Exchange Exposure 10

2.1.2 Exchange Risk and the Importance of Real Exchange Rate Changes 11

2.1.3 Purchasing Power Parity 12

2.1.4 The Multinational Corporation 13

2.1.5 Risk 13

2.1.6 Hedging 13

2.2 Literature Review 14

Chapter 3: Methodology

18

3.1 Research Design 18

3.1.1 Choice of Subject 18

3.1.2 Perspective 18

3.1.3 Preconceptions 19

3.1.4 Scientific Approach 19

3.1.5 Research Technique 19

3.1.6 Validity 20

3.1.7 Reliability 20

3.2 Approaches to Estimating Foreign Exchange Exposure 20

3.2.1 The Cash Flow Approach 21

3.2.2 The Capital Market Approach 21

3.3 Collection of Data 22

3.3.1 Multiple-Source Secondary Data 22

3.3.2 Specific Nature of Our Secondary Data 23

3.4 Model Specification 23

3.5 Testing for Significance 24

3.5.1 Hypotheses 25

3.5.2 Our Choice of Significance Level 26

3.6 Data Presentation and Analysis Aid 26

Chapter 4: Description of Sample and Data

28

4.1 Data Presentation 28

4.2 Description of Sample 28

Chapter 5: Data Presentation and Analyses

31

5.1 Spot Exchange Rate Movements – Sek/Usd and Sek/Euro 31

5.2 Percentage Changes in Spot Exchange Rates 32

5.3 Risk-Return Extimates for the Sample Firms 33

Chapter 6: Presentation and Interpretation of Results

41

6.1 Presentation of Results 41

6.2 Interpretation of Results 42

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Chapter 7: Discussion of Results, Conclusions and Recommendations

45

7.1 Discussion of Results 45

7.2 Conclusions and Recommendations 46

7.2.1 Conclusions 46

7.2.2 Recommendations 47

7.3 Further Research 47

References 49

List of Tables and Figures

Tables

4.1 Large Capitalisation Companies as at December 30th 2005 30

4.2 Mid Capitalisation Companies as at December 30th 2005 30

5.3 Descriptive Statistics of Daily Log Returns of the Sample Firms 33

6.1 Beta Coefficients for the Various Companies 41

Figures

5.1 Time Series Plot for Sek/Usd and Sek/Euro Exchange Rate Movements 31 5.2 Time Series Plot for Percentage Changes in Sek/Usd and Sek Euro Exchange Rates 32 5.2.1 Time Series Plots of Daily Log Returns Variability in the Large Cap Segment 34 5.2.2 Time Series Plots of Daily Log Returns Variability in the Mid Cap Segment 36 5.3.1 Plots for Test of Stationarity of Log Returns in the Large Cap Segment 38 5.3.2 Plots for Test of Stationarity of Log Returns in the Mid Cap Segment 39

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Acknowledgements

We wish to express our deep gratitude to our supervisor Anneli Linde for guiding us through to the successful completion of this thesis. Rikard Olsson and Anders Isaksson gave a helping hand as they read through the manuscript so as to determine if our methodology was within the limits of acceptable theories. We thank them so much for their time. The moral support we got from friends and class mates is of immeasurable proportions and we are also grateful to them for this.

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ABTRACT

This research work analyses the impact of exchange rate fluctuations on firm value. It is based on a sample of 10 Swedish multinational companies selected from two market capitalization segments (Mid and Large Cap) according to the OMX index classification. A multiple linear regression model is used to explore the dependency of the log returns (continuously compounded returns) of each of the sampled companies to the percentage changes in the spot exchange rates for the SEK/U.S. Dollar and SEK/Euro being the explanatory or independent variables. The results show that the impact of fluctuations in the SEK/euro and SEK/Dollar exchange rates on the value of a firm is not statistically significant at the 5% level of significance for 17 of the 20 exchange rate scenarios analyzed for the 10 firms under study. It also shows that firms in the Financial Industry are the most sensitive to movements in the USD and EURO while those in the Health sector were the least exposed to both currencies. Thus total systematic risk is mainly accounted for by other explanatory variables such as fluctuations in interest rates, fluctuations in inflation rates, economic growth rate variability, supply chain risks, political instability, natural catastrophes just to name a few.

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CHAPTER ONE INTRODUCTION

1.1 Problem Background

Foreign exchange exposure is increasingly becoming a primary concern for Multinational Corporations (MNCs) around the globe as their quest for taking advantage of market imperfections in foreign countries is increasing. Their investments in these countries and hence exposure to currency risk has also witnessed an increase in recent years. This has drawn a lot of attention to multinational companies to consider their net position when considering foreign investment opportunities or businesses. It is worth mentioning here that the creation of multinational corporations stem from risk diversification. Firms have to consider whether the net gain from going multinational is worth more than the cost and risk associated with foreign exchange exposure (Kiymaz, 2003).

Following the breakdown in the early 1970s, of the BrettonWoods fixed parity system;

exchange rate fluctuations and the risks inherent in such fluctuations have become an increasingly important component of multinational financial management. It has been shown by earlier Economic studies that both the cash flows of a firm’s operations and the cost of capital used in valuing the company are greatly affected by currency fluctuations. (Verschoor & Muller 2005)

The international economic environment has also been characterised by substantial exchange rate fluctuations, which occur for both real and nominal exchange rate changes.

(Williamson, 2001). Changes in real exchange rates result to departures from purchasing power parity (PPP), and have a direct effect on the value of a multinational corporation or global competitor (Williamson, 2001). “A global competitor is a company that faces substantial foreign competition. (Williamson, 2001)”. The post era of the collapse of the fixed exchange rate regime has witnessed unexpected fluctuations in foreign exchange rates varying from industry to industry especially with firms concerned with international involvement (MNCs) (Kiymaz, 2003). Exchange rate fluctuations can change and cost a firm in terms of its operating cash flows, income, and costs with a great impact on both the value and risk associated with its activities.

Soenen & Shin (1999) assert that there is a general perception that exchange rate fluctuations can have a great impact on the value of a firm with foreign operations. This implies that currency fluctuations can greatly affect the performance of firms with international operations by affecting the relative prices of domestic and foreign goods and the value of foreign-currency-denominated fixed assets and liabilities. An opposing view however, states that

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the effect of exchange rate volatility will be insignificant because Multinational companies are using various financial instruments including forwards, swaps, options and futures (Soenen &

Shin, 1999). In addition multinational firms can also eliminate foreign exchange exposure by taking long and short positions in a similar currency, thereby creating a well-balanced portfolio.

Though exchange rate fluctuations can influence domestic firms as well as multinational firms, our focus on multinational firms stems from the fact that investors today are primarily concerned with international portfolio diversification. (Hanagan & Mathur, 1983). Investors either achieve international portfolio diversification directly through direct investment in the international stock market or indirectly through investment in multinational companies. Investors are however confused on which method of diversification to apply. Should they do it through the multinational firm or through the international equity market? (Hanagan & Mathur, 1983). An investor who has a very high degree of foreign exchange risk aversion might be tempted to have the perception that multinational companies are riskier than the international equity market and therefore decide to achieve international portfolio diversification by investing in the international equity market. (Hanagan & Mathur, 1983). A less currency risk-averse investor on the other hand will decide to achieve international diversification through the multinational firm irrespective of the degree of currency fluctuation.

Researchers have advanced numerous points in support of international diversification through MNCs. These points range from spreading of risks, achievement of economies of scale and scope, increase customer base, and increase in returns from investments in marketing and innovation. MNCs are able to reap benefits that are not available to purely domestic firms (Douglass, 2006).

The creation of the European Union (EU) and the strife for a single currency by some member countries led to the creation of the European Monetary Union (EMU), which adopted a single currency (the euro) in January 1999. A total of 11 E.U countries adopted the euro. The euro was created to eliminate exchange risk so as to permit EU firms to operate free from uncertainties of changes in relative prices as a result of currency fluctuations. (Tesa &

Dominguez, 2006). This would have been good news to both domestic and multinational corporations in Sweden if they had adopted the euro as a national currency. However this has not been the case given that the Swedish Krona continues to be the national and main currency and continues to float against the euro, the U.S. Dollar and other European Union currencies such as the Swiss Franc (SF) and the Great British Pound (GBP).

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1.2 Research Questions

The study shall be structured to provide answers to the following questions ;

- Are stock returns of the sampled Swedish multinational companies affected by movements in the SEK/Euro and SEK/USD exchange rates?

- If so, are these effects statistically significant at the 5% level of significance?

- What are the policy implications of the results obtained?

1.3 Research Objectives

Our study objectives are;

- To model the dependency of stock returns of selected Swedish multinational firms on two bilateral exchange rates – SEK/Euro and SEK/USD.

- To quantify or measure the sensitivity of these stock returns to the chosen exchange rates.

- To perform a statistical test for significance of this sensitivity and therefore estimate the degree of foreign exchange exposure of the sampled firms.

1.4 Limitations and Demarcation

Our study is limited only to risk associated to multinational companies as a result of foreign exchange exposure.

Considering the time constraint and scope of the study, we would not be able to provide empirical evidence on the foreign exchange risk management strategies employed by Swedish Multinational firms as represented by our selected sample. Our analysis of foreign exchange exposure is limited only to two bilateral exchange rates – SEK/Euro and SEK/USD (USD stands for United States Dollar). Our choice of the euro and the dollar is due to the fact that they are the most highly competing currencies today. Investors are principally concerned with which currency is more stable so as to decide on whether to rebalance their portfolios in favor of euro or dollar denominated assets. We employ specific bilateral exchange rates because of the belief that they are better detectors of exposure than a trade-weighted exchange rate index as used in prior studies. Only nominal exchange rates are used like in the study by Popper, et al (1997) to estimate the betas. For simplicity, we ignore the effects of real exchange rate changes between the SEK and Euro and USD for the period under study. This is a limitation because real exchange rate changes also affect cash flows; hence stock prices and the competitive positions of companies.

The study will be limited only to 10 companies selected from the Large and mid

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market capitalization segments across five industry sectors. We have not included firms in the small market capitalization segment because very limited data is available for such firms and most of them are not multinational companies and little is known about their degree of foreign involvement.

1.5 Disposition

The remainder of this study is organised as follows:

Chapter 2 surveys the theoretical foundations and empirical findings on exchange rate exposure. We will also highlight some main conclusions of previous related studies and identify a number of unanswered questions. This we hope will serve as an intellectual base in meeting our research objectives and testing the hypotheses for our study.

Chapter 3 presents and discusses the appropriate methodology for analysing our data. We shall motivate our choice and present some advantages and limitations of the chosen method in light of alternative methods so that the reader will be able to understand the relative suitability of our methodological choice as he/she reads along. We also discuss and motivate the nature of data that we have used for the study and define our sample and some useful variables.

Chapter 4: we will describe our sample and present some basic information and performance indicators such as market share, share price, sales turnover, number of shares outstanding and industry classification.

Chapter 5 presents an analysis of the data collected in line with our chosen methodology and according to Large versus Mid-Capitalised Multinational Firms in Sweden. In this way, we hope to be able to determine whether the effects of exchange rate movements vary across the two segments, and give possible explanations from a theoretical perspective for any differences. We also compare the exposures across five industry sectors including; materials; industrials; health care; Information Technology and Financials.

Chapter 6: We present our findings, discuss the findings, do our conclusions and provide recommendations. In this chapter we will also identify areas for further research.

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CHAPTER TWO

LITERATURE REVIEW AND CONCEPTUAL FRAMEWORK .

In this chapter we have reviewed previous theories on the research area. We have also been able to identify within our review some literature gap, which we hope to make up for by the end of our work. Our review of literature is focused on currency risk management within the setting of multinational companies. We have focused on this aspect to reduce redundancy. Some key concepts that we deem vital for the readers’ better understanding of the study and that have been used throughout most of the study shall also be discussed from a theoretical perspective.

2.1 Conceptual Framework

2.1.1 Overview of Foreign Exchange Exposure

The degree to which a company is affected by currency fluctuations is referred to as foreign exchange exposure. (Shapiro, 2005). Foreign Exchange exposure can be divided into three basic types – transaction exposure, operating exposure and translation exposure.

Transaction exposure is the exposure a firm is facing regarding all its specific commercial transactions that have already been booked. The terms of these transactions are established and settled at a given time period and their exposure can easily be measured by accounting systems (Verschoor & Mullem, 2005). The measurement of transaction exposure mixes the retrospective and prospective because it is based on activities that occurred in the past but will be settled in the future. (Shapiro, 2005). The implicit or explicit contractual agreements have to be taken into account as well as when measuring the overall exchange rate exposure. While such commitments create contractual exposure, a firm’s domestic and foreign assets and liabilities, and income statement items whose values are also affected by currency fluctuations, cause translation exposure (Verschoor & Mullem, 2005). Also known as accounting exposure, its measurement is retrospective in nature as it is based on activities that occurred in the past. A third component of a company’s exposure to currency fluctuations is called operating exposure. It arises from changes in the amount of future operating cash flows (revenues and costs associated with future sales) caused by an exchange rate change hence it is prospective in nature as it is based on future activities (Shapiro, 2005). As exchange rate variations affect the relative prices of goods sold in different countries, they affect a firm’s competitive position and indirectly influence its economic environment and future growth possibilities (Verschoor & Mullem, 2005). This gives rise to another kind of foreign exchange exposure – economic exposure. Although Shapiro (2005) combines transaction and operating exposure to form economic exposure, he defines economic exposure as the extent to which the value of the firm, as measured by stock prices, will

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change when exchange rates change. Chand Sooran, (2003) assert that “It is important to measure and to have on a daily basis some notion of the firm's potential liability from financial price risk. Financial institutions whose core business is the management and acceptance of financial price risk have whole departments devoted to the independent measurement and quantification of their exposures. It is no less critical for a company with billions of dollars of internationally driven revenue to do so.”

Transaction, contractual and translation exposure can be effectively managed by well- structured hedging strategies, indirect or competitive exposure provides significant volatility in cash flows for most companies worldwide (Verschoor & Mullem, 2005). However, there is greater complexity between the relationship between exchange rate fluctuations and competitiveness and this leads to difficulty in correctly estimating economic exposure and hence hedging it efficiently (Verschoor & Mullem, 2005). These account for the reason why many foreign companies will like to keep their funds in a less volatile currency as opposed to a fluctuating currency. Even though a firm may hedge its foreign exchange contracts, limiting its transaction exposure, economic exposure is difficult to estimate and further, hedge. Economic exposure arises as a result of the fact that future profits from operating as importer or exporter depend on exchange rates, and due to its nature, this type of exposure is difficult to mute. (Faff &

Iorio 2001).

2.1.2 Exchange Risk and the Importance of Real Exchange Rate Changes

The price of one nation’s currency in terms of another currency is referred to as the exchange rate between the two currencies. It is often termed the reference currency. The dollar/pound exchange rate for example is simply the number of dollars one pound can buy. If the pound can buy 1.5 dollars it would be expressed as $1.5/£. (Shapiro, 2003). In this case the dollar is the reference currency. Taking it the other way round we can express it, as pounds per dollar and the pound becomes the reference currency. Firms that do business abroad must be ready to account for changes in exchange rates that lead to variability in their cash flows. (Solt &

Wayne 2001). Transaction exposure reflects the risk that exchange rates may change between the times a transaction is recorded and met. (Solt & Wayne, 2001). Due to its short-term nature futures and forwards can be used to hedge transaction exposure and thereby eliminate its influence on the value of a firm. (Solt & Wayne, 2001). Economic exposure on the other hand is the long-term effect of exchange rate changes on the future cash flows and thereby on stock returns. (Solt & Wayne, 2001).

It is important to distinguish between nominal exchange rate and real exchange rate because they have different implications for exchange risk and competitive positions of firms

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(Shapiro, 2005). A change in the nominal exchange rate accompanied by a disproportionate change in the price level will have significant effects on the purchasing power of one currency relative to another (Shapiro, 2005). This results in departures from purchasing power parity (PPP) and affects the relative competitive positions of domestic firms and their foreign competitors.

2.1.3 Purchasing Power Parity (PPP)

According to the absolute value of purchasing power parity, price levels should be equal worldwide when expressed in a common currency. This implies that a unit of home currency (HC) should have the same purchasing power around the world. (Shapiro, 2003). Absolute PPP is however based on certain assumptions that are not realistic reason why departures from PPP often occur.

Expressed mathematically, PPP is stated as ;

) 1 . 1 ...(

...

...

...

...

) 1 (

) 1 (

t f

t h o

t

i i e

e +

= +

Where

eo : Dollar (HC) value of one unit of foreign currency at the beginning of the period;

et : Spot exchange rate in period t;

ihand if : periodic price-level increases (rates of inflation) for the home country and the foreign country, respectively.

If 1.1 holds, then

) 2 . 1 ...(

...

...

...

...

) 1 (

) 1 (

t f

t h o

t i

e i

e +

× +

=

The value of et is known as the PPP rate. The one period version of equation 1.2 is commonly used and it is written thus:

) 3 . 1 ...(

...

...

...

...

1 1

1

f h

o i

e i

e +

× +

=

From a management standpoint, purchasing power parity is often used to forecast future exchange rates, for purposes ranging from deciding on the currency denomination of long-term debt issues to determining in which countries to build plants (Shapiro, 2005).This is of relevance to any multinational corporation.

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2.1.4 The Multinational Corporation

The advent of the industrial revolution led to the emergence of the single firm, one that specialised in the production and distribution of a single product or service (Mathur & Hanagan, 1983). As the firm grew in size, vertical and horizontal division of labour took place. Vertical division of labour was brought about by the hierarchical administrative structures while horizontal division was a result of the increased emphasis of functionalization of administrative procedures. (Hanagan & Mathur, 1983).

The single firm existed until the late 1940s when business executives started viewing the entire globe as their arena of corporate activities (Mathur & Hanagan, 1983). This difference in thinking of executives has led to the outbreak of global corporations today called Multinational Companies (MNCs). (Mathur & Hanagan, 1983). Multinational companies can operate in several countries and view each as a separate entity; that is they may be “many national”. (Mathur &

Hanagan, 1983). As an alternative, the global corporation may emphasize all nations at the same time, or take an “aggregate national viewpoint” (Mathur & Hanagan, 1983, p 135).

Irrespective of whether the Multinational Corporation is many-or aggregate-national, MNCs account for close to $200billion in foreign direct investment. (Mathur & Hanagan, 1983, p 135). The sheer volume of the MNC emphasizes their importance in the world economic order and poses an interesting question for the investors (Mathur & Hanagan, 1983, p 135).

2.1.5 Risk

In accordance with the Capital Asset Pricing Model (CAPM), companies face two types of risks including systematic and unsystematic risk and the total risk is measured by the variance or standard deviation of stock returns. (Jang & Lee, 2006). Unsystematic risk is the firm specific variability caused by firm specific events such as strikes, product defects and poor management and can be eliminated through portfolio diversification even though it remains relevant risk since not all investors hold diversified portfolios. (Jang & Lee, 2006).

Systematic risk on the other hand is risk that cannot be eliminated through portfolio diversification. It represents relative fluctuations to the market, or the risk of a stock with respect to the risk of the market portfolio. Thus, systematic risk can be changed depending upon the management of the company. (Jang & Lee, 2006).

2.1.6 Hedging

Corporations in which individual investors place their money have exposure to fluctuations in all kinds of financial prices, as a natural by-product of their operations. Financial prices

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include foreign exchange rates, interest rates, commodity prices and equity prices. The effect of changes in these prices on reported earnings can be overwhelming. Chand Sooran (2003).

Hedging involves the different ways in which firms approach this financial price risk. It is not a simple exercise nor is it a concept that is easy to pin down. Hedging objectives vary widely from firm to firm, even though it appears to be a fairly standard problem, on the face of it. And the spectrum of hedging instruments available to the corporate Treasurer is becoming more complex every day Chand Sooran (2003). Hedging instruments include derivative securities like options, warrants, forwards, futures and various forms of hybrid securities. Since hedging in itself is another broad subject that doesn’t fall within our scope of research, it won’t be necessary to go into a detailed review of derivative instruments and various reasons why companies hedge foreign exposure.

2.2 Literature Review

A large volume of literature on foreign exchange exposure and hedging activities of both multinationals and domestic firms in various industries has been published. We provide a review of some of them here.

Prior studies on exchange risk have focused on multinational firms in the United States, United Kingdom, Canada and Asia Pacific. It appears very few studies have been carried out on Swedish Multinationals as far as foreign exchange exposure and its management is concerned.

Pranborg (2005) carried out a comparative survey on foreign exchange risk management by Swedish and Korean non-financial firms in which various hedging strategies were analysed and compared. His study however, did not investigate the impact of currency fluctuations on the value of Multinational corporations and their operations. Other researchers, Gao T.(2000) for instance, investigated the impact of currency fluctuations on the value of U.S multinational firms. This study on its part did not examine an in-depth analysis of the various hedging strategies and their effectiveness in reducing exposure. Hedging currency risk entails costs and should be carried out only if the benefits to be derived from hedging outweigh the costs to be incurred.

Bengt Pramborg (2005) in a study “Foreign Exchange risk Management by Swedish and Korean Nonfinancial firms: A comparative Survey” used surveyed evidence to compare Swedish and Korean firms’ foreign exchange risk management practices. His findings suggest that there are considerable differences in hedging practices in both countries despite the existence of some similarities.

Krishnamoorthy (2001) studied the industry structure and the exchange rate exposure of industry portfolio returns. Using a time series regression conducted on a sample of industries by

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regressing the rate of change of trade-weighted U.S dollar index on the industry portfolio return while controlling for the U.S market, his findings provide evidence that industries classified as being globally competitive and those that primarily serve the consumer sector of the economy have significant levels of exposure. Pantzalis and Frasar (2004) using firm specific foreign indices provide evidence that more firms face significant exposure with firm specific indices than when a common index is used. Marshall (2000) studied the foreign exchange risk practices of large U.K, U.S.A and Asia Pacific Multinational companies. The aim of his study was to provide evidence as to whether there are differences in foreign exchange risk management practices internationally. His results conclude that there exist statistically significant regional differences in the importance and objectives of foreign exchange risk management, the emphasis on translation and economic exposures, the internal/external techniques used in managing foreign exchange risk and the polices in dealing with economic exposure. The results further provided evidence of similar policies between U.S. and U.K. multinationals with very insignificant differences. The Asia Pacific Multinationals on their part display significant differences.

Crabb (2002) in his study “Multinational corporations and hedging exchange rate exposure” using data on financial hedging activities for 276 U.S. Multinational Corporations measured the net exposure to exchange rate changes for a broad cross section of large U.S Multinational corporations. His findings show that previous findings of no significant exchange exposure for this cross section of the economy are likely due in part to the financial hedging activities of these firms.

Mauer and Martin (2005) reviewed the benefits of capital market and cash flow foreign exchange exposure estimation methods. Using a sample of large U.S. banks, they conducted a comparison of the frequency with which each method detects exposure. Their findings provide evidence of the relative strength of the capital market-based approach in expectations formation.

There is also evidence of the relative strength of cash flows to detect exposure.

Moles and Bradley (2001) examined the effects of direct and indirect currency exposure on a group of Publicly-listed, nonfinancial U.K. firms using information obtained at two points in time, during a period of sterling depreciation and then one of sterling appreciation. Comparing the results, they found that when sterling was depreciating, firms experienced increased profit margins and/or sales volumes and increases in cost of foreign sourced inputs. The reverse was true for sterling appreciation. Their results show considerable stability in the estimates of economic exposure between the two periods. These results also confirm the impact of economic currency exposure but at the same time, firms are less exposed to exchange rate movements.

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Vassalou (2000) used the Capital Asset Pricing Models (CAPM) by Solnik, Gruaer et al and Aldas and Dumas to test for the pricing of exchange rate and inflation risk in equities. Using a sample of monthly equity returns from 10 different countries, over the period January 1973 to December 1990, the results show that exchange rate and inflation risks are generally priced in equity returns of the 10 countries in their sample. Decomposing changes in exchange rates into common and residual components and estimating risk premiums he found that the exchange rate risk premium is at least partly attached to the residual component of changes in exchange rates.

The results further suggest that the pricing of the residual component of exchange rates has important implications for the pricing and hedging of exchange rate risk. Testing for the presence of U.S inflation in all 10 countries he also found that U.S inflation is indeed priced in all 10 countries.

Soenen and Shin (1999) studied the measurement of foreign exchange exposure using the cumulative translation adjustment (CTA) as a trade weighted dollar index faced by individual companies. Using the AD model like Vassalou (2000) and applying it to a sample of 5572 firm- years corresponding to 572 different firms covering the period 1983-1994, the results show that the value of the U.S Multinationals is significantly correlated with contemporaneous changes in the dollar value. They also found that the exchange rate exposure is stable over the sample period. The results also provide evidence of a significant lagged relation between changes in the dollar value and the stock price performance for a one-month period after the fiscal year end.

The lagged relation disappears for the period longer than one month after the fiscal year end suggesting that any additional exchange exposure is reflected in the stock price as soon as financial statements are available to the shareholders. The results also provide evidence of a significant positive foreign exchange exposure for small firms. This is in support of the view that even though a lot of hedging instruments are available, hedging is more common in large firms than in small firms. Although firms are positively impacted by dollar depreciation, the relationship is very different depending on the industry under consideration. There is evidence of positive relationship between changes in CTA and the stock returns for the electrical equipment while negative for primary metals. There is conclusion that U.S. multinationals are exposed to exchange risk and that investors are reflecting the exchange exposure in the firm’s stock price.

Sami et al (2005) examined the linkages in expected future volatilities among the major European currencies. Using daily data on implied volatilities of the three major European currencies: the euro (EUR), the British pound (GDP), and the Swiss Franc (CHF) quoted against the U.S dollar, and using a sample period of January 2, 2001 to September 29, 2003, the augmented Dickey-Fuller and Philips-Perron unit root tests were performed on the data. The results show that the market expectations of the future exchange rate volatilities are closely

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linked among the major European currencies. The results further provide evidence that the euro is the dominant European Currency, as its implied volatility is found to significantly affect the volatility expectations of the British pound and the Swiss Franc. The results also conclude that the volatility expectations of the euro are not influenced by the other currencies.

From the foregoing, most of the studies have focused on U.S, UK, and Asia Pacific Multinational Firms and have all used a trade-weighted index using cross sectional analysis.

Most of the studies were also carried out prior to the launch of the euro. We intend to contribute to the literature by focusing on Swedish Multinational Companies using a multiple regression model and taking into consideration the euro era. We will also investigate the differences in foreign exchange exposure across five industry sectors and across the two market capitalisation segments (Large Capitalisation and Small Capitalisation Segments).

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CHAPTER THREE METHODOLOGY

3.1 Research Design

3.1.1 Choice of Subject

Our decision to research on this subject stems from knowledge gathered from previous studies in Finance and International Financial Management in particular. We find the topic

“Foreign Exchange Exposure of a selected number of Swedish Multinational Firms” particularly interesting and important because of the dramatic rise in the volume of international transactions over the past 50 years. As a consequence, the foreign exchange market has by far become the largest financial market in the world with average foreign exchange trading volume in 1998 being estimated at $1, 5 trillion daily1.

However, foreign currency trading volumes dropped after 1998 mainly because of the replacement of 12 European currencies with the euro. Sweden did not join so the Swedish Crown has continued to float against the Euro, instead of the 12 currencies that disappeared. The forex market however still remains the largest financial market in the world.

It is also amazing how arbitrageurs, with their sound knowledge of foreign currency prices and exchange rate trends, can take advantage of imperfections in the Forex market and earn huge zero investment profits.

Previous literature reviewed concerning the subject area provides evidence that foreign exchange exposure is a cause for concern for MNCs so we thought it necessary to investigate the sensitivity of stock returns of some Swedish MNCs to exchange risk.

Our findings will provide evidence on how relative fluctuations in the euro and the dollar versus the Swedish Krona affect the value of Swedish MNCs. Knowledge of the impact of these fluctuations on a multinational company’s value would enable the management of Swedish MNCs to determine whether to hedge against foreign exchange exposure or not and to adopt the most suitable hedging strategies if necessary.

3.1.2 Perspective

Perspective refers to the different views people have on a particular subject. It serves as a lens that makes people in different fields view a problem in different ways. This can be as a result of previous studies, what they have seen and their past experiences. (Sunders et al, 2003)

1 BIS 71st Annual Report, p. 99.

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We have adopted a stock analyst’s perspective throughout our study to be able to better appreciate stock market reaction to exchange rate volatility and its impact on firm value. Also from our previous studies we believe that the view we have on our thesis work will be in line with the International Financial Orientation that has been impacted on us. We also view this research study from an economic perspective because our focus is on economic exposure that affects the long run competitive positions of multinational corporations.

3.1.3 Preconceptions

Knowledge, education, social background and practical experience constitutes preconception that is inherent in a researcher before he/she goes into a research. This however should not be allowed to influence the research work. (Sunders et al, 2007). Our preconception comes from our previous studies in International Finance, Statistics, and analysis of financial data. This has led us to choose a topic from a Finance Area.

3.1.4 Scientific Approach

There are two main types of scientific approaches to tackle a research problem. They include the deductive and inductive approaches. Under the deductive method, a theory and hypothesis (or hypotheses) are developed and a research strategy is developed to test the hypothesis. The inductive approach on the other hand enables the researcher to collect data and develop theory depending on the results obtained from analysing the data. (Sunders et al, 2007).

This study is going to adopt the deductive approach. We have started by forming a theoretical framework, which we later use to compare and analyse the scientific findings. A theoretical exposition of underlying theories that govern the research topic will be done and we will go ahead to develop a set of hypotheses, which will be tested by analysing quantitative data using multiple regression analysis. The results from the analysis will provide evidence as to whether the hypotheses stated earlier about the effects of the independent (explanatory) variables on firm value (the dependent variable) would be accepted or not.

3.1.5 Research Technique

There are two main types of research techniques – quantitative and qualitative. The qualitative technique implies an emphasis on non-numerical values and the qualities of entities and processes that are not experimentally examined or measured in terms of quantities, amounts, intensity or frequency. Quantitative technique on the other hand emphasises the measurement and analysis of causal and effect relationships between variables, not processes. (Sunders et al, 2007).

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A quantitative technique will be adopted because the study is dealing with numeric values like time series data that can be easily analsyed using suitable data analysis procedures like graphs, tables and statistics. The research technique is aimed at providing us with an appropriate path to the study so as to enable us arrive at a reliable and good conclusion.

3.1.6 Validity

Validity tries to investigate if the findings are fairly presented. That is, are the findings actually what they appear to be? Is the relationship between two variables a causal relationship?

It is also the extent to which the data collected truly reflects the problem being studied. (Lewis &

Thornhill, 2003). Our data was collected from the Stockholm stock exchange of the OMX, which has up to date information on the Swedish Stock Market. We shall also see that there is a causal relationship between stock returns of our sampled companies and the exchange rates used. We are therefore sure of the validity of our findings. However, our research results are not generalisable (external validity) because we have conducted a case study research on a small number of companies. Therefore the purpose of our research is not to produce a theory that is generalisable to all populations but simply to try to explain what is going on in our particular research setting.

3.1.7 Reliability

This refers to the extent to which a data collection technique or analysis procedures will yield consistent findings. It can be assessed by posing the following three questions (Easterby- Smith et al., 2002; 53 quoted by Saunders et al, 2007; 149);

- Will the measures yield the same results on other occasions?

- Will similar observations be reached by other observers?

- Is there transparency in how sense was made from the data?

We think the study is reliable because the results we have obtained are consistent with those of other researchers in different countries as seen in our theoretical frame of reference.

Also the measures and data analysis procedures and tools employed are very likely to yield the same results in other occasions for the sampled companies if the same data is used. There is transparency in how the data has been analysed and interpreted given that SPSS has been our data analysis and interpretation aid.

3.2 Approaches to Estimating Foreign Exchange Exposure

Two main approaches to estimating foreign exchange exposure can be identified. These include the Cash Flow Approach and the Capital Market Approach ;

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3.2.1 The Cash Flow Approach

The cash flow approach on the other hand is past oriented and focuses on the impact of exchange rate changes on current cash flows. Since the cash flow-based methodology captures accomplished exposure patterns it allows a decomposition of exposures into short-term and long- term components and therefore has the advantage of distinguishing between transaction and economic exposure. Hedging effectiveness may render cash flow exposure difficult to identify unless it is measured on cash flows net of hedging. Also, it has the disadvantage of being considered as incomplete since it does not include expectations about the future and hence, does not measure the effect of currency fluctuations on the value of a firm. (Verschoor & Muller, 2005).

3.2.2 The Capital Market Approach

Under the capital market approach, a study by Verschoor & Muller (2005), states that the exchange rate exposure of firm i is simply measured by the part of firm i’s stock return variance that is correlated to exchange rate fluctuations. This is often referred to as the total exposure of firm i. However, since other macroeconomic variables may vary with exchange rate fluctuations and stock returns, some studies include them in the exposure model so as to accurately estimate the proportion of variance in stock returns attributable to currency fluctuations. (Verschoor &

Muller, 2005). The regression model we have used in the study has isolated the effects of other macro-economic variables for simplicity.

We shall use the capital market approach to quantify foreign exchange exposure. This approach has been widely used and proven to be successful in detecting exposure. Dumas (1978) and Adler and Dumas (1980,1984) first suggested that foreign exchange exposure could be quantified as the sensitivity of stock returns to exchange rate movements. This approach has been widely used and proven to be successful in detecting exposure.

To the extent that exchange rate risk is a priced factor, understanding the sensitivity of stock returns to exchange rate movements is of special importance for analysts, investors and portfolio managers. Knowing the degree of foreign exchange exposure of a firm’s equity allows an investor to increase or decrease equity holdings to reflect their risk tolerance. If the portfolio manager is not willing to decrease his holdings, the investor may choose instead to decrease his exposure to foreign exchange risk by hedging (Laurence & Martin, 2005). Applying this method to the five categories of firms is intended to give stakeholders a better perception and comparison of foreign exposures amongst the various groups and hence reallocate resources if necessary.

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Company managers are also concerned about the capital market perception of their exposures, for at least two reasons. First, if exchange rate risk is a priced factor, then the cost of equity is impacted by the degree of foreign exchange exposure. Thus managers need to consider their exposures in ascertaining an appropriate discount rate to evaluate investment opportunities.

Second, compensation in the form of stock and/or stock options induces managers to heavily focus on stock price performance hence they have an incentive to make adjustments in their exposure to foreign exchange risk in order to receive payoffs from granted stock and/or stock options. (Laurence & Martin, 2005).

A limitation however with this model is that it does not allow for a decomposition of exposures into short and long term components. This would have been useful for understanding the nature of the existing exposures and evaluating the effectiveness of hedging programs.

(Verschoor & Muller, 2005).

3.3 Collection of Data

We have used time series data in our study which is a quantitative secondary data.

Different researchers (for example, Bryman, 1989; Dale et al., 1988; Hakim, 1982, 2000;

Robson, 2002) quoted by Saunders et al (2007) have generated a variety of classifications for secondary data but three main sub groups of secondary data can be identified : documentary data, survey-based data and multiple-source secondary data. We found that the latter (multiple source secondary data) fits best for the study and more specifically suitable for meeting our research questions and objectives.

3.3.1 Multiple-Source Secondary Data

“This can be based entirely on documentary or on survey secondary data, or can be an amalgam of the two. The key factor is that different data sets have been combined to form another data set prior to your accessing the data” (Saunders et al, 2007). Examples of multiple- source secondary data include various compilations of company information like shares price listings for different stock markets, sales, profits, number of employees etc over a period of time (Saunders et al, 2007). From our literature review, we read books and journal articles on our chosen topic and this provided us with an idea of the sort of data that we will need and that are available so we find our choice of multiple-source secondary data most appropriate for the study.

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3.3.2 Specific Nature of our Secondary Data

Due to the capital market approach chosen and described in our methodology section, and in order to meet our research objectives, our data shall be based on the close prices of 10 Swedish Multinational firms listed on the Stockholm Stock Exchange market. This data shall be downloaded from the stock exchange website www.stockholmborsen.se over a seven year period from January 1999 to December 2005 (time series data). Out of a total membership of 87 companies on the Stockholm Stock Exchange as at 04th April 2006, there are 35 Swedish banks and securities companies most of which are multinationals.

Because the capital market approach adopted for our data analyses and discussion is based on measuring the sensitivity of stock returns to exchange rate movements, we shall compute stock returns from the close prices downloaded and analyse but returns rather than prices for two main reasons (i) returns are scale free and (ii) have better statistical properties than prices.

Data on specific bilateral exchange rates shall be used to measure exposure. Using a multiple regression model (described in 3.4 below) to measure the sensitivity of firm value to exchange rate movements, parameters in the model shall be estimated with respect to two bilateral exchange rates, namely the SEK/Euro and the SEK/dollar exchange rates from January 1999 to December 2005.

We have focussed on the euro and the dollar because they are major currencies and likely to be the greatest concern for Swedish multinational firms given their high degree of international trade flows in these currencies. They are the most highly competing currencies considering the influential roles of European (Eurozone) and US markets in the world today. The euro replaced the national currencies of the 11 countries that joined the European Monetary Union (EMU) on January 1, 1999 followed by Greece in January 1, 2000. These 12 EMU members account for over 60% of Europe’s stock trading. Adding the London trading in stock from these countries imply that some ¾ of stock trading in Europe and almost ¼ of global stock trading is now Euro denominated. (Stockholm Stock Exchange) The dollar on the other hand has been the anchor of the international financial system since the collapse of fixed exchange rates in the early 1970s. (Kaikati, 1999).

3.4 Model Specification

Given that foreign exchange risk constitutes only a portion of the total systematic risk faced by companies, we shall first determine the degree of total firm risk that is explained by currency fluctuations. If the proportion appears to be statistically significant then we will conclude that currency risk has a great impact on the multinational company’s value and thus would recommend hedging programs for the highly exposed groups of MNCs in our sample

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based on certain incentives and criteria. We assume that unsystematic risk can be diversified away and hence should not constitute part of total firm risk that matter to investors.

A company faces exchange risk to the extent that variations in the home currency of the unit’s returns are correlated with variations in the nominal exchange rate. Shapiro (2005). Using regression analysis we shall measure the amount of risk that is explained by currency fluctuations by estimating the values of βi0, βi1… βip in the following multiple regression model:

) 1 . 3 ...(

...

...

...

, ,

0 ,

,t i USD USDt EURO EUROt t

i X X

y =β +β ∆ +β ∆ +ε

Where

yit(Dependent variable) = The stock return estimate for firm i at time t.

t

XUSD,

∆ , ∆XEURO,t = The percentage changes in the nominal spot exchange rates (SEK value of one unit of foreign currency – USD and Euro) during period t.

0 ,

βi = Intercept of the regression line for firm i.

EURO i USD i,,

β = Parameters of the regression model, which represent the sensitivities of firm i’s stock returns to the various percentage changes in the exchange rates (SEK depreciation/appreciation against the USD and Euro respectively).

εt= A random error term with zero expected value (surprises that will affect stock returns over period t, assumed to have a mean value of zero for a well diversified multinational).

Assuming the latter holds true equation (3.1) reduces to:

) 2 . 3 ...(

...

...

...

, ,

0 ,

,t i USD USDt EURO EUROt

i X X

y =β +β ∆ +β ∆

Depending on the sensitivities of the multinational corporation’s stock returns to exchange rate changes between the SEK versus the Euro and USD, we will be able to compare the effects of the two bilateral exchange rate movements on the multinational firm in the two market capitalization segments across five industry sectors. This will enable us to conclude whether currency risk constitutes a large portion of the total risk of the sampled multinational firms and thus determine whether hedging is advisable or not.

3.5 Testing for Significance

Significance is a statistical term that tells how sure you are that a difference or relationship exists between or among variables. But also how strong or weak a significant relationship is and how large or small a significant difference is. It just depends on the sample size. (Anderson et al, 2005). To answer our research questions, we shall test for a significant regression relationship in

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equation 3.2 above. We are going to conduct a hypothesis test (t Test) to determine whether the values of ßUSD and ßEUR are zero. If stock returns and the two bilateral exchange rates are related, we must have ßUSD, ßEUR zero The purpose of the t test is to enable us conclude whether ßUSD, ßEUR ≠ zero.

3.5.1 Hypotheses

The hypotheses to be tested follow from the parameters of the multiple regression model stated in equation 3.2 above. Using the SEK as the reference currency of the selected Swedish Multinational companies, we state the hypotheses as follows

:

Ho: Stock returns of the sampled companies are not sensitive to fluctuations in the euro and the dollar at a 5% statistically significant level for the period considered.

Ha: Stock returns of the sampled companies are sensitive to fluctuations in the euro and the dollar at a 5% statistically significant level for the period considered.

Symbolically, we state the hypotheses as follows :

0 :

0

0:

=

USD a

USD

H H

β β

0 :

0

0:

=

EURO a

EURO

H H

β β

If Ho is rejected, the test gives us sufficient statistical evidence to conclude that one or more of the parameters are not equal to zero and that the relationship between stock returns (the dependent variable) and the set of independent variables (SEK/USD and SEK/ Euro) is significant. However, if Ho cannot be rejected, it means we do not have sufficient statistical evidence to conclude that a significant relationship is present between the two variables.

3.5.2 Our Choice of Significance Level (α - Level)

Our critical α - Level of 5 % or 0, 05 shall be used as a criterion to either reject or not reject our null hypothesis stated above. In other words 0, 05 is the error rate we are willing to accept meaning that we want to be 95% confident that our results are free from error or bias.

Traditionally, most research studies have used either the 0, 05 level or the 0, 01 level. We found the 0,01 (and other rates less than 0, 05) too conservative and therefore more appropriate for research studies in very sensitive areas like aeronautics, medicine, etc where error rates should be minimised to the lowest possible level because human lives are at stake. We can therefore say that the choice of α- Level is subjective and should depend on the research area. Sunders et al,

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(2007) however recommend that significance levels should be set at 0, 01 rather than 0, 05 so as to minimise Type I errors i.e. rejecting a null hypothesis when we should not or concluding that two or more variables are related when they are not or more generally in business and management research, wrongly coming to a decision that something is true when in reality it is not.

3.6 Data Presentation and Analyses Aid.

We note here that we are going to make use of the specialized software on analyzing financial data called SPSS in our Data Presentation and Analyses section. It is accurate, efficient and not cumbersome as is the case with manual computations. This shall be useful in the following areas of our study:

• To estimate the parameters (ß) for our regression model (in equation 3.2) used to measure the sensitivity of stock returns to exchange rate fluctuations.

• To compute stock returns, or better still log returns based on close prices data for our sample firms. As earlier mentioned above, stock returns, instead of prices shall be analyzed for reasons we know already. They shall be computed as follows:

) 3 . 3 ...(

...

...

1

1

= +

it it

it p

r p

Where

1 1

=

it it it

it p

p r p

pti = Close price observed for firm i at day t;

1

pit = Close price observed for firm i at day t-1

To obtain better results we shall use the continuously compounded return because it is scale free and has better statistical properties. It is calculated thus:

) 4 . 3 .(

...

...

...

log log

) log(

) 1

log(

1

1

=

= +

=

it it

it it it

it

p p

p r p

y

• To compute the cumulative log returns (CLR) for each firm using the formula below :

+

=

+ + + ≡

+

=

T

N T T

i N

T i T

i T

i T i T

i LR LR LR LR LR

CLR

1 ,

2 , 1 , ,

, ... ...(3.5) Where:

T

CLRi, : Cumulative log returns of firm i at time T and N: Total number of periods (years) under study.

T

LRi, : Log returns of firm i at time T.

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• To compute percentage changes in daily spot exchange rates for the chosen currencies computed as follows ;

) 5 . 5 ( ...

...

...

...

...

...

...

100

1 1 ,

, ×

 

 −

=

it t i it t

i E

E X E

Where;

t

Xi,

= Change in exchange rate of currency i at time t

,t.

Ei = Exchange rate of currency i at time t.

1.

, −t

Ei = Exchange rate of currency i at time t-1.

• To explore the statistical properties of our data to be able to arrive at logical conclusions and to estimate the t-statistic to measure significance levels of foreign exposure for our sample.

The data will be presented using, tables, graphs and charts.

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CHAPTER FOUR

DESCRIPTION OF SAMPLE AND DATA 4.1 Data Presentation

Our study uses daily stock prices from 10 Swedish Multinational Companies from the Stockholm Stock Exchange of the OMX index as at 31st December 2005. This index is a presentation of the Nordic listed companies divided into market capitalization (Large Cap, Mid Cap and Small Cap) segments. Given that OMX index allows the downloading of daily closed prices but not the daily returns, the returns are therefore calculated as shown in equations (3.3) through (3.4) in chapter three. These returns are calculated as the log differences of the stock prices. To test for stationarity in the returns the cumulative abnormal returns (CAR) will be calculated for each firm and a time series plot of this variable will help us determine if they are stationary through time or not.

Exchange rate data was downloaded from Thomson data stream. This database consists of the daily spot exchange rates for the Swedish krona and Euro and that for the Swedish krona and U.S dollar. DataStream is the world’s leading database that contains historical data on various data sets ranging from stock prices, interest rates, futures, options, forwards and so on. It is therefore the most reliable source of data because renowned experts manage and update it almost instantaneously with new information. Our data sample runs from the period January 1st 1999 to December 31st 2005.

4.2 Description of Sample

The sample is compiled by selecting five firms from the first two OMX market capitalization segments (Large Capitalization and Mid Capitalization) across five different industry sectors (Materials, Industrials, Health Care, Information Technology, and Financials), one from each industry. This is to enable us compare the exposure across the market capitalization segments and thereafter across the industries. To be included in the study the firm has to be a multinational corporation with international involvement, has transactions in euros and dollars, has the SEK as its functional currency and has available data for the period under study. The firm is also suppose to be classified as Large-or Mid-capitalised. Firms from the last market capitalization segment (small caps) have therefore been eliminated due to lack of up-to- date data for the period under study and due to insufficient information about their international involvement.

From the foregoing the firms in tables 4.1 and 4.2 have been selected across five industry sectors including Industrials, Financials, Information Technology, Materials and Health Care

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from the two market capitalization segments Large-Cap and Mid-Cap for tables 4.1 and 4.2 respectively. These industries have firms that meet all our criteria for inclusion in the study. That is, being multinational, having the SEK as the functional currency, having transactions in euros and US dollars and having available data of daily stock prices throughout the sample period. For example, AB Volvo (or Aktiebolaget Volvo), the world-leading Swedish manufacturer of commercial vehicles, buses and construction equipment, drive systems for marine and industrial applications, aerospace components and services carries out manufacturing in 18 countries and sales in more than 185 markets. (http://www3.volvo.com/investors/finrep/ar05/eng/index.html).

Volvo has a market capitalization of 49397million SEK.

Large capitalization firms include firms with a market capitalization equivalent to EURO 1billion or more. Mid capitalization firms include firms with a market capitalization of less than EURO 1billion but above EURO 500million and small capitalisation firms include firms with a market capitalisation of less than EURO 500million.

References

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