Applied Econometrics and International Development

Vol.9-1 (2009)

ECONOMIC EXPOSURE TO EXCHANGE RATES IN JORDAN COMPANIES:

THEORETICAL FRAMEWORK AND LITERATURE REVIEW

SHOTAR, Manhal M.
EL-MEFLEH, Muhannad A.
Abstract
Jordans exports and imports represent more than 36% and 81% of Jordans GDP
respectively. Therefore, not only is Jordans economy highly vulnerable to change in the
exchange rate, but also individual firm performances are vulnerable as well. The
sensitivity of the firms future income to exchange rates change is a necessary measure
for the risk management of the firm since economic exposure of the firm affects the profit
and the value of the firm. Two variants of an exchange risk model for major Jordanian
firms are proposed. These models were developed and estimated. There are two major
findings of this paper: (1) the models provide useful information on the economic
exposure of Jordanian firms; and (2) the firm exchange rate exposure is above the market
portfolio exposure.
JEL Classification: F41, F43, E52
Key Words: Economic Exposure, Economic Openness, Risk Management.
1. Introduction
The Jordanian dinar (J.D) has been effectively pegged to the dollar since 1995 (J.D
0.71/$ 1.) The depreciation of the dollar during 2002-2008 as well as the free trade
agreement with the U.S. has helped Jordans exports. However, the increase of Jordan's
exports could slow down if the U.S. dollar appreciates. The Jordanian dinar will also face
a potential crisis if a Palestinian currency is introduced. The net impact of an increase in
oil prices on the Jordanian economy is not clear since oil prices have a positive impact on
labor remittances and grants for Jordan from Arab oil producing states. On the other
hand, Jordan is an importer of oil.
The lack of foreign exchange hedging by major firms in Jordan means that the central
Bank of Jordan needs to accumulate larger amounts of foreign reserves than needed to
deal with the potential of an unexpected bail out of private firms in case of currency
attack. The accumulation of foreign reserve by the Central Bank of Jordan is costly and
represents a public subsidy for private firms (for more details see El-Mefleh. 2003.)
Jordan exports few commodities to their major trading partners in the Arab countries, the
U.S., and India. The 2001 free trade agreement between Jordan and the U.S. did increase
Jordan exports to the U.S. from less than J.D 10 million in 1999 to more than J.D 750
million by the year 2007. This increase in exports made the U.S. the most important
market for Jordanian exports in terms of monetary value. Then again, Jordans imports
come mostly from European countries, Arab countries, the U.S., and China. Imports from

Manhal M. Shotar, Ph.D. (Contact Author), Senior Finance Economist, Gesellschaft fr

Technische Zusammenarbeit (GTZ), Amman Jordan, e-mail: mshotar@hotmail.com
Muhannad A. El-Mefleh, Ph.D., Qatar University, Doha, Qatar, P.O. Box 2317,
e-mail: melmefleh@yahoo.com

Applied Econometrics and International Development

Vol.9-1 (2009)

China did surpass those of the U.S. for the first time in 2004. The imports from the Arab
countries mostly are fuel oil.
Jordans small open economy has little influence if any on internationally traded goods
and services prices with an estimated GDP of JD 11.352 billion in 2007. Jordans exports
and imports in 2006 represent more than 36% and 81% of Jordans GDP respectively.
The degree of openness measured as the ratio of exports and imports to GDP is 1.17.
Jordans economy is highly vulnerable to external shocks. Therefore, not only is Jordans
economy highly vulnerable to changes in the exchange rate but also to individual firm
performances. The sensitivity of the firms future income to exchange rates change is a
necessary measure for the risk management of the firm since economic exposure of the
firm affects the profit and the value of the firm. Consequently, measuring and managing
the economic exposure of a firm is essential for strategic management. In addition,
understanding economic exposure gives the firm the ability to implement effective
hedging strategies. The higher the ratio of foreign sales to total sales for a company, the
higher the firm exposure is to exchange rate risk. Examining the market structure that a
firm is operating in, both in the local and foreign markets is essential to understanding the
impact of economic exposure due to unexpected shifts in the real exchange rate. Changes
in real exchange rate could eliminate the profit margin of the importer but increase it for
the exporter and vice versa, based on the elasticity of demand facing the firm.
The present paper focuses in its second section on providing a theoretical background
and comprehensive review of the relevant literature. Section three discusses the
methodology employed as well as the empirical test results. Section four provides final
remarks. Finally, section five concludes the paper.
2. The Critical frame work literature review.
The end of the Bretton Woods system in March 1973 did create new challenges for
firms. One of the new challenges is managing real operating exposure due to unexpected
changes in real exchange rates. The change of real exchange rates and price requires firms
to engage in short-term hedging and long term strategic planning so that the firms can
protect themselves and stay competitive in the international market. The long term
planning will include strategies for expected and unexpected currency exchange rate
influence on sourcing and plant location.
One would expect that the financial sector is the most vulnerable to exchange rate risk,
but there is no known data on whether the banking sector engages in foreign exchange
hedging or not. The firm that faces exposure to exchange rate fluctuation can adopt
financial hedging, operational hedging, or a combination of both. The objective of the
firm is to decrease the degree of its exposure to foreign currency fluctuation. One way of
managing exchange rate exposure is to enter into foreign exchange forward contracts
which can protect the firm from the short-term fluctuation of exchange rates but not from
the deterioration of its competitiveness when domestic currency appreciates. Forward
contracts can be designated as cash flow hedge or fair value hedges of liabilities or assets
denominated in foreign currency by accounting departments.
There are three strategies to exchange rate risk: the do nothing strategy, a passive
strategy, and an active strategy. The do nothing strategy is a simple and straightforward one, converting foreign currency into local currency at the spot market rate. The
passive strategy of the importer is one in which hedging all expected foreign exchange

134

Shotar,M.M. and El-Mefleh,M.A. Economic Exposure to Exchange Rates in Jordan Companies

positions in the forward market or all payments for futures of imported inputs are
negotiated for payments in the local currency (suppliers assume the exchange rate risk.)
The active strategy is based on the firm selectively hedging its exchange rate risk based
on forecasting. Therefore, the firm may hedge, not hedge (maintaining an open position)
or negotiate payments in the local currency intentionally based on its forecast of the
movement of exchange rate. There is value in an active strategy if the forecasting of the
exchange rate by the firm (or the forecast purchased by the firm) is superior to relying on
forward rate alone.
Another way of managing exchange rate exposure is the use of foreign sourcing which
has become an essential part of any multinational/global firm strategy during the last 20
years. Foreign sourcing enhances the competitive advantage of the firm in producing
components, assembly, marketing, services, and design. The foreign sourcing can be from
subsidiaries located outside the country or from suppliers from abroad. In theory, one
would expect the decision for foreign sourcing to be motivated by easier access to foreign
consumers and cheaper input factors, as well as avoiding tariff barriers, non-tariff
barriers, and exchange rate risk.
Japanese firms set up production facilities in the U.S. because of the depreciation of
the dollar during the last 20 years, vis--vis the yen. Consequently, Japanese firms
increased the purchase of standardized parts and materials from the U.S. suppliers not
only for their operation in the U.S. but for their operations in Japan. Most companies are
not willing to outsource their core competency due to economic rent but that does not
prevent corporations, especially multinational firms, from exploiting comparative
advantage of different countries by establishing subsidiaries around the globe.
Subsidiaries give firms the ability to exploit economies of scale and keep the benefits of
global strategy.
The extent of a companys involvement in foreign markets can be estimated by using
the ratio of foreign assets to total assets, foreign profits to total profits, and foreign sales
to total sales of the firm. One would expect that the higher the previous three ratios the
more sensitive the firm profit would be to exchange rate fluctuations. Malindretos and
Tsanacas (1995) have argued that based on their survey, the chief financial officers
(CFOs) of small sized multinational corporations (MNCs) have a better understanding of
transaction or translation exposure than they have of economic exposure. Also, they find
that diversification of the financial base is the hedging technique used against translation
exposure, the forward hedging technique is used against transaction exposure, and the
diversification of finance and operations technique are used against economic exposure.
According to Khim and Liang (1997) most firms in Singapore are engaged
significantly in hedging transaction exposure with forward contracts, but economic
exposure is not hedged in any significant measure. Economic exposure cannot be hedged
using matching fund techniques, but it requires the use of marketing, production, and
financial strategies.
Flood and Lessard (1986) have divided the cash flows of the firm into two categories
that have different sensitivities to exchange rate changes. The two categories are the
operating cash flows and the nominal flows such as accounts receivable and most debt.
They divide the operating exposure into conversion effect (translation effect) and
competitive effect (dependence effect) where competitive effect is dependent on the
exchange rate of the domestic currency and the structure of the markets in which the firm
sells its products or/and buys its inputs.

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Applied Econometrics and International Development

Vol.9-1 (2009)

Allayannis and Ihrig (2001) have found that 4 out of 18 industrial groups in the U.S.
are subject to exchange rate exposure. The exchange rate movement impacts the
competitive positions, export shares, and imported input shares of the four industrial
groups. However, the extent of the impact is dependent on the market structure. In a
highly competitive market, the impact of unexpected exchange rate could be devastating
relative to an oligopolistic market structure. A firm in an oligopoly market structure has a
price above marginal cost (markup) which gives the firm the ability to deal with exchange
rate movement effectively by following a discriminatory price structure for each market.
Consequently, the impact of exchange rate movement on revenue is smaller than that of a
firm in a competitive structure.
Bodnar and Wong (2003) argue that measuring exchange rate exposure or elasticity of
the exchange rate exposure of a firm by the standard approach of regression analysis of
stock returns on an exchange rate change and on market portfolio return produces
primarily unsatisfactory statistically significant coefficient of exchange rate change. This
measure creates a dilemma for the practical usefulness of these models. Bodnar and
Wong conclude that the longer the horizons of the return measurements are for the U.S.
firms, the more statistically significant the exchange rate exposure coefficient estimates
are. This result is contradicted by the findings of Oh (2004) which were that daily data
has better explanatory power than the monthly data for the Korean firms.
Bradley and Moles (2002) study has found that more than 75% of UK firms consider
the impact of the exchange rate when adopting operational decisions. Also, the operation
decision is based on other factors, such as competitive market conditions, comparative
advantage, and economies of scale in production and distribution.
Hakkaraineen, Kasanen, and Puttonen (1997) have investigated Finnish firms
responses to globalization and the adoption of a floating exchange rate regime in October
1992 by the Finland Central Bank. Their findings indicate an active management of
exchange rate risk. Their survey also shows that various hedging instruments are used.
3. Methodology, data, and empirical results.
A firms rate of return is a function of rate of return of the domestic market portfolio,
the weighted rate of return of the domestic market, the rate of change in the exchange rate
index, or the price of the same product by major competitor. The rate of return is also a
function of other variables, such as the number of foreign competitors, input prices,
substitute prices, technological variable, government policy variable, and number of
domestic importer. If the historical rate of return is not available, then one has to rely on
indirect measure to calculate the rate of return by using the following formula:
Rt = (vt + dt - nst -vt-1) / vt- (1)
Where Rt is the rate of return for a firm at time t, vt is the expected value of the firm at
time t, dt is the amount of dividend during at time t, and nst is the value of the public
offering of new shares by the firm at time t.
Globalization and the increase of international trade as a percentage of the world GDP
during the last 30 years has made a larger percentage of corporation performances
vulnerable to unexpected exchange rate movement. The increase in the value of foreign
currency has an economic and accounting impact on the firm, especially on multinational

136

Shotar,M.M. and El-Mefleh,M.A. Economic Exposure to Exchange Rates in Jordan Companies

corporations. The following model is a similar model to that of Chan-Lau (2005), Oh and
Lee (2004), Loudon (2004), Bodnar and Wong (2003), Domingues and Tesar (2001),
Aabo (2001), Pantzalis, Simkins, and Laux (2001), Miller (1998), and Adler and Dumas
(1984).
One way to measure the economic exposure is by estimating the coefficient of changes
in the exchange rate.
Rit = ai+ biRmt + ciEt + di Pj t + eit

(2)

Where Rit is the rate of return of firm i, Rmt weighted rate of return of the domestic market
or domestic market portfolio, Et rate of change in the exchange rate index or relevant
exchange rate, Pjt is the price of the same product or similar product by major competitor,
bi is the firm beta, ci is the exchange rate impact on the rate of return (exposure risk), and
eit is the error term. The inclusion of market portfolio return is to capture the impact of all
other macroeconomic factors.
One must be careful when using market value of the firm over time by adjusting for
dividend payments, which reduce the value of the firm, and public offering of new shares,
which increase the value of the firm. The exchange rate Et is the rate of local currency in
terms of the foreign currency. Et is expected to be negative when local currency
depreciates and positive otherwise. The expected sign of ci is dependent on the expected
inflows (revenue) and outflows (costs) of foreign currency. Interest rate is not included in
the equation because interest rate is incorporated in the return of the market. If c i is zero,
then the firm has the same level of exposure as the market exposure (or market portfolio
exposure.) A positive value for ci implies that the firm value or return on the firm i
increased with the appreciation of the domestic currency. A negative value of ci implies
that the firm value declined due to appreciation of the domestic currency. Using the equal
weight market portfolio tends to increase the importance of small, mostly import-oriented
firms in the portfolio. The above firms will see that their cash flow decreases when
domestic currency depreciates but increases when the domestic currency appreciates.
Using a value-weighted market portfolio gives more weight to large, most likely exportoriented, firms in the portfolio. These large firms will see that their cash flow decreases
when domestic currency appreciates and increases when domestic currency depreciates.
Therefore, one would conclude that the construction of market portfolio would impact the
empirical result of the regression.
Data:This paper uses the monthly general stock exchange price index, published by
Amman Security Exchange for the period of May 2004 until March 2007. Also, the
monthly closing price of a share of The Arab Potash is taken at the start of each month
from Amman Security Exchange. The average price of Potash per ton in $ is calculated
from the data provided by the Jordans ministry of industry and trade.
Empirical results:
Rit = 2.6Et 0.016Pj t
(2.3) (1.67)
Rit = 0.43Rmt + 2.8Et + 0.01 Pjt
(1.4)
(2.5) (1.19)

F=4.87
F=4.04

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Applied Econometrics and International Development

Vol.9-1 (2009)

Two models are estimated. The estimated equations represent satisfactory statistical fits
of the t-value, f-value, and expected sign of the coefficients of regressions. One model is
without the market portfolio. The coefficient of the real exchange rate of model one is the
total exposure elasticity of the firm. The second model which includes the market
portfolio variable improves the explanatory power of the regression and gives the
decision makers extra information about the exchange rate impact on the value of the firm
and the exposure of the firm to real exchange rate fluctuation. A significant positive
coefficient of the exchange rate (2.8) implies that the firm exchange rate exposure is
above the market portfolio exposure.
The test results in this paper contradict with other researchers. Kroon and Van
Veen (2004) have examined more than 2600 stocks from more than twenty countries and
have found that the exchange rate exposure impact on an average companys stock value
in most cases is zero. The reason is that most exchange rate impact is NOT reflected
through the general market movements.
Final remarks:
Jordan needs to foster foreign exchange risk management in the private sector. The
development of a foreign exchange derivatives market will promote the financial stability
of the country in the absence of financial distress. But the availability of foreign exchange
derivatives will accelerate and deepen the financial instability of the country during
financial crisis. The ability of speculators to take positions in the forward market and
swap market will reduce the ability of the central banks to defend the exchange rate.
Jordan exports a few commodities to their major markets in Arab countries, India, and
the U.S. which may strengthen the argument for moving toward a flexible exchange rate
system. A flexible exchange rate system may help export to new markets, protect the
countrys competitive advantage, and reduce the impact of real shock, not monetary
shock on the economy. The persistent high rate of unemployment in Jordan indicates
inflexibility of wages downward, even with Jordans lack of strong labor unions,
unemployment benefits, and intensive regulations. Movement toward a flexible exchange
rate regime may create doubts about the ability of the monetary policy to stay disciplined
and keep inflation rates low. The inability to predict a stable inflation may create a
decrease in demand for Jordanian currency and may increase the demand for other
currencies instead. The level of dollarization in Jordan may create a problem for the
monetary authorities if it shifts toward a flexible exchange rate. The increase of currency
substitution will make it difficult for the monetary policy to control the money supply and
increase the volatility of the exchange rate, especially when the monetary authority lacks
credibility in the eyes of the public.
4. Conclusion.
Jordans exports and imports represent more than 36% and 81% of Jordans GDP
respectively. Therefore, not only is Jordans economy highly vulnerable to change in the
exchange rate, but also individual firm performances are vulnerable as well. The
sensitivity of the firms future income to exchange rates change is a necessary measure
for the risk management of the firm since economic exposure of the firm affects the profit
and the value of the firm. The lack of foreign exchange hedging by major firms in Jordan
means that the central Bank of Jordan needs to accumulate larger amounts of foreign

138

Shotar,M.M. and El-Mefleh,M.A. Economic Exposure to Exchange Rates in Jordan Companies

reserves than needed to deal with the potential of an unexpected bail out of private firms
in case of currency attack. Finally, Jordan needs to foster foreign exchange risk
management in the private sector.
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On line Annex at the journal Website: http://www.usc.es/economet/aeid.htm

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Shotar,M.M. and El-Mefleh,M.A. Economic Exposure to Exchange Rates in Jordan Companies

Annex:
Year
04-5
04-6
04-7
04-8
04-9
04-10
04-11
04-12
05-1
05-2
05-3
05-4
05-5
05-6
05-7
05-8
05-9
05-10
05-11
05-12
06-1
06-2
06-3
06-4
06-5
06-6
06-7
06-8
06-9
06-10
06-11
06-12
07-1
07-2
07-3

Potash
st
3,78
4,4
4,4
4,44
4,48
5,8
8,51
10,99
13,33
12,95
13,05
12,45
13,17
12,99
12,7
15,39
15,2
14,3
13,45
13
13,8
13,3
11,75
11,29
10,7
9,22
9,99
10
10
10
10,1
11
13,8
13,9
13,45

G
SEPI
1794,6
1883,6
1997,9
2064,8
2085,2
2232,1
2384,5
2684,6
2837,7
3069,7
3266,1
3633,2
4067,8
4119,2
4706,1
4368,4
4616,7
4558,5
4551,4
4690,7
4404,8
4480,8
3689,9
3667,9
3815
3643,3
3135,1
3177,9
3405,5
3293,6
3264,7
3014
3025,6
3267,3
3397,9

$/
euro
1,2
1,2146
1,2266
1,2191
1,2224
1,2507
1,2997
1,3406
1,3123
1,3013
1,3185
1,2943
1,2697
1,2155
1,2041
1,2295
1,2234
1,2022
1,1789
1,1861
1,2126
1,194
1,2028
1,2273
1,2767
1,2661
1,2681
1,281
1,2722
1,2617
1,2888
1,3205
1,2993
1,308
1,3246

Ppotash
119,42
133,52
128,353
137,438
129,497
143,089
140,246
141,739
156,698
150,728
160,28
159,445
158,613
158,582
158,55
174,873
170,871
171,145
169,547
173,276
160,353
173,906
175,22
176,516
174,516
171,042
157,942
173,544
174,203
169,734
175,996
174,344
171,521
175,132
168,112

Yen/
$
109,56
108,69
111,67
109,86
110,92
105,87
103,17
103,78
103,58
104,58
106,97
105,87
108,17
110,37
112,18
111,42
113,28
115,67
119,46
117,48
117,18
116,35
117,47
114,32
111,85
114,66
114,47
117,23
117,91
118,01
117,23
115,57
118,72
121,29
115,86

GP
Stock
0,164021
0
0,009091
0,009009
0,294643
0,467241
0,291422
0,212921
-0,02851
0,007722
-0,04598
0,057831
-0,01367
-0,02232
0,211811
-0,01235
-0,05921
-0,05944
-0,03346
0,061538
-0,03623
-0,11654
-0,03915
-0,05226
-0,13832
0,083514
0,001001
0
0
0,01
0,089109
0,254545
0,007246
-0,03237

Potash st: potash stock price

Gpstock: is the growth rate of potash stock price
GSEPI: General stock exchange price index
P-Potash is the price in dollars per ton of Potah
Gpstock: is the growth rate of potash stock price
GGSEPI is the growth of the general stock exchange price index
G$/euro is the rate of change in the exchange rates

Gp-potash: is the rate of change in price of potash

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Applied Econometrics and International Development

Year
04-5
04-6
04-7
04-8
04-9
04-10
04-11
04-12
05-1
05-2
05-3
05-4
05-5
05-6
05-7
05-8
05-9
05-10
05-11
05-12
06-1
06-2
06-3
06-4
06-5
06-6
06-7
06-8
06-9
06-10
06-11
06-12
07-1
07-2

GG
SEPI
0,049593
0,060682
0,033485
0,00988
0,070449
0,068277
0,125854
0,057029
0,081756
0,06398
0,112397
0,119619
0,012636
0,142479
-0,07176
0,05684
-0,01261
-0,00156
0,030606
-0,06095
0,017254
-0,17651
-0,00596
0,040105
-0,04501
-0,13949
0,013652
0,07162
-0,03286
-0,00877
-0,07679
0,003849
0,079885
0,039972

G
$/euro
0,012167
0,00988
-0,00611
0,002707
0,023151
0,039178
0,031469
-0,02111
-0,00838
0,013218
-0,01835
-0,01901
-0,04269
-0,00938
0,021095
-0,00496
-0,01733
-0,01938
0,006107
0,022342
-0,01534
0,00737
0,020369
0,040251
-0,0083
0,00158
0,010173
-0,00687
-0,00825
0,021479
0,024597
-0,01605
0,006696
0,012691

Vol.9-1 (2009)
GpPotash
0,118071
-0,0387
0,070781
-0,05778
0,10496
-0,01987
0,010646
0,105539
-0,0381
0,063372
-0,00521
-0,00522
-0,0002
-0,0002
0,102952
-0,02289
0,001604
-0,00934
0,021994
-0,07458
0,08452
0,007556
0,007396
-0,01133
-0,01991
-0,07659
0,098783
0,003797
-0,02565
0,036893
-0,00939
-0,01619
0,021053
-0,04008

Gyen
/$
-0,00794
0,027417
-0,01621
0,009649
-0,04553
-0,0255
0,005913
-0,00193
0,009654
0,022853
-0,01028
0,021725
0,020338
0,016399
-0,00677
0,016694
0,021098
0,032766
-0,01657
-0,00255
-0,00708
0,009626
-0,02682
-0,02161
0,025123
-0,00166
0,024111
0,005801
0,000848
-0,00661
-0,01416
0,027256
0,021648
-0,04477

Gyen/$ is the rate of change in the exchange rate of yen/$

$/euro is taken from: Federal Reserve Statistical Release, G5. Foreign Exchange Rates (Monthly). This
release is available at: http://www.federalreserve.gov/releases/g5.
Yen/$ is available at: http://en.wikipedia.org/wiki/Yen#Historical_exchange_rate
This is the closing price of a share of The Arab Potash at the start of each month.
Amman Security Exchange, Amman Stock Exchange Indices are available at:
http://www.ase.com.jo/pages.php?menu_id=198&local_type=0&local_id=0&local_details=0
*GSEPI: generel stock exchange price indices (Amman Security Exchange)
P-Potash is the average price per ton in $.
P-Phosphate is the average price per ton of phosphate rock in dollar

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