A note on common methods used to estimate foreign exchange exposure

Understanding the impact of foreign exchange risk is a critical element for purposes of firm valuation and risk management. In this study, we review the benefits of capital market and cash flow foreign exchange exposure estimation methods, and using a sample of large U.S. banks, we conduct a comparison of the frequency with which each method detects exposure. We find some evidence of the relative strength of the capital market-based method in expectations formation, since about 25% of the sample that does not show significant cash flow sensitivity to the pound has significant stock price sensitivity. We also find evidence of the relative strength of cash flows to detect exposure. Across all five currencies examined, when cash flows have exposure, the capital market regularly (70-100% of the time) does not find the exposure to be significant.