The Importance of Cash Flow News for Internationally ... ANNUAL...stock returns into the variance terms of cash flow news and discount rate news (expected rate of return news), and

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The Importance of Cash Flow News for

Internationally Operating Firms

Alain Krapl and Carmelo Giaccotto

Department of Finance, University of Connecticut

2100 Hillside Road Unit 1041, Storrs CT 06269-1041

[email protected], 980-216-9829

[email protected], 860-486-4360

We thank Assaf Eisdorfer and Tom O’Brien for their helpful comments.

January 2011

Abstract

Previous studies show that stock prices are primarily driven by discount rate news, indicating

that changes in expected returns are more persistent than changes in expected cash flows. We

argue that investors distinguish between foreign- and domestic based cash flow news in the sense

that foreign based cash flow news is more permanent in nature than domestic based cash flow

news. Potential explanations include additional frictions that internationally operating firms face,

as well as the informational content of export news in the sequential internationalization process

(Johanson and Vahlne (1977)). Applying Campbell’s (1991) variance decomposition framework

we find that cash flow news becomes more important for net importing and net exporting firms

relative to firms with a low propensity of receiving foreign based cash flow news.

Keywords: Variance Decomposition, Cash-Flow News, Foreign Currency Exposure,

Internationalization Process

EFM Classification Code: 330

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1. Introduction

This paper investigates if investors treat foreign based cash flow news of internationally

operating firms differently from U.S. market based cash flow news of domestically operating

firms. Using the log linear dividend ratio model of Campbell and Shiller (1988), Campbell

(1991) uses a vector autoregressive (VAR) approach to decompose the variance of unexpected

stock returns into the variance terms of cash flow news and discount rate news (expected rate of

return news), and its covariance term; he shows that expected returns news are primarily

responsible for moving market-level stock returns. Similar results are found by Campbell and

Ammer (1993), who study the returns of bond and stock markets more broadly. Vuolteenaho

(2002) shows that firm-level stock returns are mainly driven by cash flow news and then

reconciles his findings with those of Campbell (1991) by demonstrating that cash flow news can

be diversified within portfolios while discount rate news series are highly correlated across firms.

Campbell and Vuolteenaho (2004) decompose the CAPM beta into a cash-flow-beta and

discount-rate-beta, arguing that news about future cash flows should have a higher price of risk.

Moreover, Eisdorfer (2007) finds that cash flow news become more dominant for financially

distressed firms and that more bankruptcies occur following negative cash flow shocks than

positive discount rate shocks.

This paper contributes to the existing literature by demonstrating that foreign-based cash

flow news is more important in the pricing process of internationally operating firms than U.S.

market based cash flow news for the pricing of domestically operating firms. The increased

relative importance of foreign based cash flow news can be explained by existing economic

literature. First, internationally operating firms face substantial frictions such as entry and exit

costs associated with exporting a product or operating production facilities abroad. Frictions can

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make it more cumbersome and costly for a firm to react to a negative or positive cash flow shock

therefore rendering the cash flow news for an internationally operating firm more permanent

relative to the cash flow news of a purely domestically operating firm.

Second, Johanson and Vahlne (1977) describe the internationalization process of firms as

a sequence that starts by exporting a product and then moves to the establishment of a foreign

sales subsidiary, to licensing agreements and similar contracts before actual investment in the

form of foreign production facilities takes place. The individual firm moves from a relatively low

risk export oriented stage to a higher risk foreign production stage that involves foreign direct

investment (FDI). According to the Johanson and Vahlne’s (1977) model, the firm’s initial step

in the internationalization process is product export to a foreign market whereby the firm

acquires valuable knowledge of supply and demand conditions, business culture, risks (such as

country risk), growth opportunities, competition, structure of foreign institutions etc. Based on

the role of exports in the knowledge gathering process, one could infer an increased permanence

of cash flow news (that is specifically related to news about exports) for net exporting firms

(firms that have a net long foreign currency position). Invaluable knowledge that is gathered by

firms during the export stage is used to make long term investment decisions. Assuming

sufficiently efficient financial markets, investors would utilize this information and incorporate it

into their valuation process of internationally operating firms, resulting in the increased

importance of cash flow news.

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Using Campbell’s (1991) approach we decompose the returns of all firms on Nasdaq,

Amex and the NYSE, using data from January 1973 to December 2009, and find that cash flow

news is more persistent, i.e. dominant for firms that have an increased propensity of receiving

foreign based cash flow news (either net importer or net exporter firms, as measured by their FX

equity exposure).

The paper proceeds as follows: Section two describes the variance decomposition

framework as introduced by Campbell (1991), and the estimation process of a firm’s propensity

of receiving foreign based cash flow news as opposed to domestic based cash flow news. Section

three describes the data, section four presents the empirical findings, and section five concludes.

2. Methodology

2.1 Variance Decomposition Framework

Campbell (1991) and Campbell and Ammer (1993) use a log-linear dividend-ratio model

that was introduced in Campbell and Shiller (1988) to decompose unexpected real stock returns

into changes in the rational expectations of future dividend growth and future stock returns.

Following Campbell (1991) the unexpected real stock returns follow:

Where is the log real return on a stock from the end of period to the end of period ,

is the log real dividend paid during period , and is a constant of linearization, a

number little smaller than one1. Equation (1) signifies that for unexpected real stock returns to be

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where is the sample mean of the log dividend price ratio. Campbell and Shiller (1988) discuss the

approximation process whereas Campbell and Mei (1993) and Vuoleenaho (2002) find that equation (1) holds well

for a wide range of possible

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positive, future dividend growth has to increase, or expected future stock returns have to

decrease, or both. Equation (1) can be rewritten as:

Where:

Following from equation (2), the variance of unexpected stock returns can be decomposed into

the variance and covariance terms of cash flow and expected rate of return news:

Further, Campbell (1991) shows that news about cash flows and news about future returns can be

expressed as:

Where: , being the matrix of vector autoregressive (VAR) parameters

(the companion matrix of the VAR system) that result from the estimation of a first-order VAR

system of the form: (where is the vector of the VAR variables and is the

vector of the error terms with a corresponding variance/covariance matrix that is denoted by .).

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denotes a vector whose first element is one and whose other elements are zero. Following (7)

and (8), the variance and covariance terms of equation (6) can be expressed as:

2.2 Estimating a Firm’s Propensity of Receiving Foreign Based Cash Flow News

In order to test for the difference between foreign based cash flow news and domestic

based cash flow news, it is necessary to estimate the level of international involvement or

exposure of a firm, following the notion that a firm with a high level of international activity will

experience more international cash flow innovations relative to the mostly domestic-operating

firm that has neither cost nor revenue sources abroad.

To avoid substantially limiting the data sample and to capture the whole spectrum of a

firm’s international exposure, this paper uses foreign currency equity exposure as a proxy of the

level of international involvement. Jorion (1991), based on the work of Adler and Dumas (1984),

suggested the following widely used model for the estimation of firm FX equity exposure:

Where is stock ’s individual returns at time , is the return of the value-weighted U.S.

market index at time , and is the return of foreign currency (usually a basket of

currencies), measured in USD terms at time . Although equation (12) has been commonly used

in the empirical literature, we modify the model to account for uncertainties in the timing

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between changes in FX rates and equity returns2 (see Amihud (1994)) by estimating a Dimson-

version of the equity FX exposure coefficient based on Dimson (1979).

Where and are based on OLS-estimates of Equation (14):

where is the CRSP holding period return of stock for month , is the monthly return of

the value-weighted U.S. market index during month ,

is the continuously

compounded rate of return of the major currency basket as measured by the USD for time period

. During the first part of this study, the Dimson-Gamma, which is given by equation (13),

estimates the firm’s level of post-hedging FX equity exposure. We use this measure to form

twenty-five size / FX equity exposure portfolios to demonstrate the importance of cash flow

news for firms that have international exposure. This follows from the notion that firms with

higher (in absolute value terms) FX equity exposure are more likely to experience international

cash flow innovations relative to firms with little FX equity exposure.

3. Data

As suggested by Eisdorfer (2007), we use three different VAR specifications. First,

following Campbell (1991), we include the log of realized stock returns (including dividends),

the dividend yield, and the relative bill rate as the predictive variables in the VAR system.

Second, following Larrain and Yogo (2008), we replace the dividend yield with net payout,

2 The literature on FX exposure is vast. See Bartram and Bodnar (2007) for an overview of the FX exposure puzzle

and issues such as the time-relationship between equity returns and changes in FX rates.

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which is dividend plus equity repurchase net of newly issued equity3. As suggested by

Vuolteenaho (2002), the third VAR specification uses return on equity (ROE) as the predictive

cash flow variable.

All data span the period from January 1973 to December 2009 and include all firms listed

on Nasdaq, Amex and the NYSE. Monthly stock return data were taken from CRSP, the monthly

major currency index (MCI) data come from the Federal Reserve’s H10 tables, the monthly risk

free rate was retrieved from Kenneth French’s website, and firm net income data was obtained

from the quarterly Compustat files.

Table I presents the summary statistics, Pearson correlation matrix, and tests of

stationarity for: 1) The monthly excess return of the U.S. value-weighted market index, 2) the

relative bill rate which is the difference between the one-month U.S. treasury bill rate and its

twelve-month backward moving average, 3) the FX equity exposure measure, or Dimson-

Gamma, which follows the approach suggested by Jorion (1991) with a modification suggested

by Dimson (1979), 4) the monthly dividend yield that was calculated by using with- and without

dividend stock returns data from CRSP, following the approach by Fama and French (1988), 5)

net payout which is dividends and stock repurchases net of new equity issued, following Larrain

and Yogo (2008) and Eisdorfer (2007), 6) returns on equity (ROE) which is the sum of four

quarters of net income, divided by current firm market capitalization (Vuolteenaho (2002) and

3 Following Boudoukh, Michaely, Richardson, and Roberts (2007), the net payout for firm in month is calculated

by:

Where is the number of shares outstanding, is the cumulative factor to adjust shares, is the month-end share

price, and is the cumulative factor to adjust price. All data is available from CRSP.

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Eisdorfer (2007)) , and 7) the trade weighted continuously compounded monthly return of a

basket of foreign currencies of major U.S. trading partners, expressed in USD terms4.

All variables with the exception of Dimson-Gamma and dividend yield are stationary at

the 5 percent confidence level.

[Insert Table I approximately here]

4. Empirical Findings

In the first part of this section we present the results of the variance decomposition using

three different specifications of the VAR model to ensure robustness of our results with respect

to different cash flow proxy variables. In the second part of this section we expand our analysis

by estimating a series of multivariate regression models to further illustrate our main findings.

Vuolteenaho (2002) shows that cash flow news can be diversified by forming portfolios

while expected rate of return news is highly correlated across firms. This means that portfolio-

level variance decomposition results can be affected by the level of diversification within

portfolios, therefore we choose to decompose individual firm stock returns first, and then

subsequently form our different portfolios of interest. This approach rules out any diversification

effects on the variance decomposition results.

In order to study the difference between domestic and foreign cash flow news for a firm,

it is necessary to first, sort firms by size (equity market capitalization) and then second, by a

proxy for the firm’s propensity of receiving foreign cash flow news as opposed to domestic cash

flow news (Dimson-Gamma which is a measure of firm FX equity exposure). It is necessary to

4 This monthly rate of return is calculated by first-differencing the log of the reciprocal of the major currencies index

(MCI) as reported by the Federal Reserve Bank of the United States, H10 Tables.

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control for firm size due to size effects on both, the firm’s variance decomposition results, as

well as its effect on FX equity exposure. Vuolteenaho (2002) finds that the variance of cash flow

news, the variance of expected rate of return news, and the covariance terms of the two news

components decrease approximately monotonically with firm size (as measured by equity market

capitalization). Moreover, Vuolteenaho (2002) finds that cash flow news becomes more

important with firm size. There is also empirical evidence that firm size affects FX equity

exposure measures mostly supporting the hypothesis that small firms have higher FX exposure

measures than bigger firms (see Dukas et al. 1996 and Chow and Chen 1998).

Table II shows the VAR decomposition results using realized stock returns, dividend

yield and the relative bill rate as the predictive variables. Individual firm variance decomposition

results are trimmed by excluding 1% of the outliers in each tail, and sorted into twenty-five

size/FX equity exposure double sorted portfolios. Sorting the portfolios based on FX equity

exposure (Dimson-Gamma) should separate firms with a high post-hedging FX equity exposure

from firms that have little exposure to changes in FX rates. It follows that firms with a high (in

absolute value terms) FX equity exposure have a higher propensity of receiving foreign-based

cash flow news relative to firms with little FX equity exposure. Size 1 denotes the portfolio that

contains the smallest size firms whereas the Size 5 portfolio contains the largest firms (as

measured by average equity market capitalization). Firms with the most negative FX equity

exposure are assigned to FX 1. In this study this portfolio contains firms whose stock price

declines with a strengthening of the foreign currency basket, i.e. a weakening of the USD. Such

firms have a net short FX position or could be essentially called net importers from an FX

perspective. FX 3 contains firms that have little-to-no FX equity exposure, which are likely to be

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firms that have a lower propensity of receiving foreign cash flow news. FX 5 contains net

exporter firms, or firms that have a net long FX position.

Panel A in Table II reports the average relative importance of cash flow news for firms

that are assigned to each portfolio. The relative importance of cash flow news is defined as the

variance of cash flow news as a percentage of the variance of unexpected stock returns

. Consistent with Vuolteenaho (2002), cash flow news dominates expected rate of

return news on individual firm level. More importantly, Panel A shows that within each of the

size portfolios we can observe that the average relative importance of cash flow news is higher

for the FX 1 and FX 5 portfolios, and the lowest for the FX 3 portfolio. This U- or V- shaped

pattern of the relative importance of cash flow news confirms our hypothesis that cash flow news

is more important for firms with high FX equity exposure, i.e. firms that have a higher

propensity of receiving foreign-based cash flow news relative to firms that have little FX equity

exposure, or a much lower propensity of receiving foreign-based cash flow news. This

observation would be consistent with the notion that investors perceive foreign based cash flow

news to be more persistent than domestic based cash flow news. Panel C in Table II

demonstrates that this U- or V- shaped pattern is also present in the average covariance terms,

indicating that internationally operating firms experience a higher level of interaction between

cash flow and discount rate news, adding to the total unexpected return volatility; this

observation is similar to Vuolteenaho’s (2002) finding that the covariance terms of cash flow and

expected rate of return news are of a higher magnitude for smaller firms.

The results in Panel A indicate that cash flow news is, on average, more important for net

exporting firms within the Size 1, Size 2, Size 3, and Size 4 portfolios (105.7%, 113.1%,

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114.8%, and 111.2% for net exporters, compared to 102.8%, 109%, 109.1%, and 107.4% for net

importers). There does not seem to be a substantial difference in the importance of cash flow for

net importers and net exporters within the largest firm size portfolios.

[Insert Table II approximately here]

Figure 1 demonstrates graphically, the increasing importance of cash flow news for firms

that are exposed to the risks of international operations. The relative importance of cash flow

news is defined as the variance of cash flow news as a percentage of the variance of unexpected

returns

which is depicted on the vertical axis of the graphs. The firm-level variance

decomposition used realized stock returns, dividend yield and the relative bill rate as the

predictive variables. Firms where then sorted into 25 portfolios based on average firm size and

FX equity exposure. The horizontal axis show the various FX portfolios where 1 contains net

importing firms, 3 has firms with little to no FX equity exposure, and 5 contains net exporting

firms. As hypothesized most firms display predominantly U- or V- shaped patterns of the

relative importance of cash flow news, confirming the more permanent nature of foreign based

cash flow news. The U-shape pattern is least pronounced for small size firms and becomes more

substantial with the size of the firm (Size 4 and Size 5 portfolios depict the most pronounced U-

shapes).

[Insert Figure 1 approximately here]

The different treatment of cash flow news by investors may be due to two main

differences: First, firms who operate internationally, i.e. firms that have either production

facilities abroad or export their products to foreign markets, experience substantially higher

frictions. These additional frictions are the result of numerous factors that could be summarized

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under the umbrella of country risk. Exporting firms face barriers to entry and often barriers to

exit which affects their ability to react to negative demand shocks for their product in foreign

based markets5. Similarly, internationally operating firms might find it more cumbersome and

costly to adjust their cost structure when their production facilities are located in countries with

economies that do not conducive to rapid cost cutting (countries with large proportions of

organized labor, or complex labor laws etc.). This can lead to foreign based cash flow news

being more permanent than domestic based cash flow news.

Second, as described by Johanson and Vahlne (1977), exports play a key role in the

internationalization process of firms. Based on their model, a firm’s exporting activities are used

as an important step in their knowledge development which is a key factor in the

internationalization process. Based on this notion, foreign based cash flow news, especially for a

net exporting firm would have more permanent effects on the unexpected returns for the firm

than comparable news for a non-exporting firm. Investors would be aware that firms use

international cash flow news to make key long-run decisions which would result in an increased

persistence of cash flow news.

Variance decomposition results are affected by the choice of predictive variables in the

vector autoregressive system. Following Eisdorfer (2007), we use two alternative specifications

of the vector autoregressive model. As suggested by Larrain and Yogo (2008), net payout, which

is dividend payments plus net repurchases (repurchases minus newly issued equity) might be

better cash flow measure for the VAR system. Table III reports the variance decomposition

results that use realized stock returns, net payout and the relative bill rate as predictive variables.

5 One of the consequences of market frictions and additional uncertainties in international trade is hysteresis. See

Dixit (1989), Baldwin (1988), Baldwin and Krugman (1986) for readings on this topic.

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Consistent with the findings of Larrain and Yogo (2008) and Eisdorfer (2007), the average

importance of cash flow news for firms is higher when using the net payout as the cash flow

proxy. Similar to the findings in Table II, cash flow news play a more important role for larger

firms. More importantly, cash flow news on average is more persistent for net importer and net

exporter firms, confirming our hypothesis. As observed in the results in Table II, cash flow news

seem to be slightly more permanent for net exporter firms relative to net importers with the

exception of size quintile five (containing the largest firms). The news covariance terms are also

more substantial for internationally active firms (confirming our findings in Table II). Figure 2 is

a graphical representation of the results in Panel A of Table II and emphasizes the U- and V-

shaped patterns of the relative importance of cash flow news.

[Insert Table III approximately here]


The second alternative cash flow proxy, as used by Vuolteenaho (2002), is return on

equity (ROE). Due to the availability of financial statement data, the frequency changes from

monthly to quarterly, significantly reducing the number of observations. In addition, the

availability of financial data from Compustat decreases the number of firms in our sample

substantially (from 11,968 to 6,305 firms). As suggested by Eisdorfer (2007), in order to avoid

any seasonality in firm earnings, we measure ROE as the sum of the past four quarters of net

income divided by the current market capitalization of the firm. Table IV, and Figure 3 show

that, albeit with more noise (likely due to the loss of observations and the noise generated by

using financial statement data), our previous findings are robust to the choice of predictive

variables in the VAR system.

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[Insert Table IV approximately here]


In the following part of this section we include an analysis of regression results that use

the relative importance of cash flow news (measured as the following ratio:

) as the

dependent variable and the firm’s propensity of being exposed to foreign based cash flow news

as the explanatory variable while controlling for firm size (measured as the log of average firm

equity market capitalization). The VAR system used to estimate the relative importance of cash

flow news uses log realized returns, dividend yield and the relative bill rate as predictive

variables. Table V presents the regression results of equation (15):

Where is the average of firm ’s variance of cash flow news as a percentage of the

variance of unexpected returns (

), is the absolute value of the Dimson-Gamma

measure of firm , and is the natural log of the average market capitalization of firm .

Based on the hypothesis that cash flow news become more persistent or dominant with the

increasing propensity of the firm of obtaining foreign-based cash flow news, should be

positive in sign.

Panel A presents the estimates of equation (15) using the entire sample (11,968 firms),

whereas Panel B breaks the sample into net importers (6,673 firms) and net exporters (5,295

firms), Panel C presents the results of the Chow test where There is no statistical difference

between the estimates of equation (15) between net importers and net exporters.

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The results in Panel A show that, on average, for each increase in the absolute value of

the Dimson-Gamma measure of a firm, the relative importance of cash flow news increases by

4.5 percent, controlling for firm size. This result confirms my initial findings in Table II and

provides further support for my hypothesis. The slope coefficient on the log of average firm size

indicates that the importance of a firm’s cash flow news increases with firm size. This finding is

consistent with Vuolteenaho’s (2002) observation that discount rate news is relatively more

important for small firms. Both results are statistically significant at the 99-percent level.

Separating the sample into net importers and net exporters allows testing for differences between

net importers and net exporters. The Chow test (in Panel C) rejects the null hypothesis of no

difference between the two groups on the 99-percent level. The results in Panel B suggest that,

on average, the positive relationship between the importance of cash flow news and the firm’s

level of internationalization is stronger for net exporting firms ( is 0.05079 for net exporters

compared to 0.04497 for net importers).

[Insert Table V approximately here]

5. Conclusions

This study tests the hypothesis that cash flow news for internationally operating firms is

more permanent in nature than cash flow news for firms that mostly operate domestically, which

leads to increased persistence of international cash flow news. Using three different VAR

specifications, we decompose firm level stock returns of all firms on Nasdaq, Amex and NYSE

and find empirical evidence that cash flow news is more important for net importing and net

exporting firms relative to firms that have little to no post-hedging FX equity exposure. This

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indicates that investor’s value firms that have foreign-based cash flows in a different manner

than they do firms that mostly have domestic based cash flow innovations.

Furthermore, our regression results suggest that the dominance of cash flow news is more

substantial for net exporting firms than net importing firms. We also confirm the findings of

Vuolteenaho (2002) who finds that cash flow news is relatively more important for large firms

and that on individual firm-level, cash flow news dominates discount rate news.

The increased permanence of cash flow news could be attributed to the existence of

additional frictions for internationally operating firms and the sequential process of

internationalization that is described by Johanson and Vahlne (1977).

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Table I

Descriptive Statistics, Stationarity Tests and Correlation Matrix

Table I presents descriptive statistics, stationarity tests and a Pearson correlation matrix for the following

variables: The market excess return is the difference between the monthly returns of the value-weighted

U.S. market index including dividends and the one-month treasury bill rate. The relative bill rate (RREF)

is the difference between the one-month treasury bill rate and its one-year backward moving average.

where and are OLS estimates of:

therefore Dimson-Gamma

denotes the FX equity exposure coefficient that is estimated by using a Dimson (1979) version of the

approach suggested by Jorion (1991). The monthly dividend yield is computed using the returns with and

without dividends from CRSP, using the approach developed by Fama and French (1988). Net Payout is

computed following the methodology of Boudoukh, Michaely, Richardson, and Roberts (2007) and is

equals dividends plus stock repurchases minus new equity issued, divided by market equity. Return on

equity (ROE) is calculated by adding the past four quarters of net income, divided by market equity

(Eisdorfer (2007), Vuolteenaho (2002)). The major currency index denotes the monthly log returns of a

trade-weighted basket of currencies of major U.S. trading partners as defined by the Federal Reserve Bank

of the United States (This is equal to 1/MCI Index). P25, P75 indicate the 25th and 75th percentiles of

each variable, and the ADF statistic denotes the augmented Dickey-Fuller unit root test. All results are

based on monthly data on all firms listed on the NYSE, Amex, and Nasdaq during the period of January

1973 to December 2009.

Descriptive Statistics Tests of Stationarity

Mean Stdev. P25 Median P75 ADF Tau P-Value

Market Excess Return 0.4943 4.7001 -2.2063 0.9282 3.5615 -9.7889 0.0000

RREF -0.0078 0.0970 -0.0600 -0.0083 0.0517 -6.4443 0.0000

Dimson-Gamma -0.0935 0.0515 -0.1237 -0.0977 -0.0728 -1.1809 0.2174

Dividend Yield 3.0726 1.1737 1.8483 3.1429 4.0799 -1.0596 0.2612

Net Payout -0.1559 6.0476 -1.5063 0.3986 2.1093 -7.5865 0.0000

ROE 3.8594 28.8209 4.0646 5.6205 7.6982 -6.2274 0.0000

Major Currency Index 0.0756 2.0789 -1.2481 0.0556 1.2343 -9.7585 0.0000

Correlations

Mkt.

Return RREF

Dimson-

Gamma

Dividend

Yield

Net

Payout ROE

MCI

Index

Market Excess Return 1.000 -0.119 -0.010 0.053 0.005 -0.142 0.146

RREF

1.000 -0.035 0.016 -0.105 0.203 0.012

Dimson-Gamma

1.000 0.398 0.192 -0.084 -0.071

Dividend Yield

1.000 0.287 -0.043 -0.015

Net Payout

1.000 -0.036 -0.063

ROE

1.000 -0.045

Major Currency Index 1.000

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Table II

Variance Decomposition when the Predictive Variables are Realized Return, Dividend Yield, and

the Relative Bill Rate

Table II reports the variance decomposition results of unexpected returns of 25 double-sorted equal-

valued portfolios, using holding period stock returns including dividends, dividend yield (calculated

using Fama and French (1988) approach), and the relative bill rate, as the predictive variables. The

variance components are estimated as follows: , , and

, where , is a vector whose first element is one

and whose other elements are zero, and denote expected return news and cash flow news, is

the coefficient matrix of the following first order VAR system: , and is

the average ratio of the market price to the sum of the market price and the dividend, in this sample .

Size 1 is the portfolio that contains the smallest firms, Size 5 the largest firms (as measured by average

market capitalization). FX 1 contains firms with low Dimson-Gamma measures, i.e. firms that have a

net short foreign currency position, such as net importing firms, FX 3 contains firms with little equity

FX exposure, while FX 5 contains firms that have a net long foreign currency position, such as

exporting firms. Panel A, B and C report the portfolio averages of individual firm variance

decompositions. Panel A reports the variance of cash flow news as a percentage of the variance of

unexpected stock returns , Panel B shows the variance of expected return news as a

percentage of the variance of unexpected returns , and Panel C reports the covariance

between and multiplied by a factor of -2.

Panel A: Variance of Cash Flow News (Percentage Weight)

Size 1 Size 2 Size 3 Size 4 Size 5

FX 1 1.028 1.090 1.094 1.074 1.054

FX 2 1.008 1.038 1.029 0.968 0.910

FX 3 0.990 0.997 0.986 0.944 0.863

FX 4 1.003 1.028 1.043 0.988 0.921

FX 5 1.057 1.131 1.148 1.112 1.048

Panel B: Variance of Discount Rate News (Percentage Weight)


FX 1 0.125 0.177 0.182 0.203 0.235

FX 2 0.146 0.174 0.200 0.215 0.276

FX 3 0.161 0.177 0.204 0.220 0.240

FX 4 0.149 0.160 0.200 0.229 0.259

FX 5 0.149 0.183 0.182 0.201 0.196

Panel C: Covariance Term - (Multiplied by Factor -2)


FX 1 -0.152 -0.267 -0.276 -0.277 -0.289

FX 2 -0.153 -0.212 -0.229 -0.183 -0.186

FX 3 -0.151 -0.175 -0.190 -0.164 -0.103

FX 4 -0.152 -0.188 -0.242 -0.217 -0.180

FX 5 -0.206 -0.314 -0.331 -0.313 -0.245

22

Table III

Variance Decomposition when the Predictive Variables are Realized Return, Net Payout, and the

Relative Bill Rate

Table III reports the variance decomposition results of unexpected returns of 25 double-sorted equal-

valued portfolios, using holding period stock returns including dividends, net payout (calculated using

Boudoukh et al (2007) approach), and the relative bill rate, as the predictive variables. The variance

components are estimated as follows: , , and


and whose other elements are zero, and denote expected return news and cash flow news, is the

coefficient matrix of the following first order VAR system: , and is the

average ratio of the market price to the sum of the market price and the dividend, in this sample . Size 1 is

the portfolio that contains the smallest firms, Size 5 the largest firms (as measured by average market

capitalization). FX 1 contains firms with low Dimson-Gamma measures, i.e. firms that have a net short

foreign currency position, such as net importing firms, FX 3 contains firms with little equity FX exposure,

while FX 5 contains firms that have a net long foreign currency position, such as exporting firms. Panel

A, B and C report the portfolio averages of individual firm variance decompositions. Panel A reports the

variance of cash flow news as a percentage of the variance of unexpected stock returns

, Panel B shows the variance of expected return news as a percentage of the variance of

unexpected returns , and Panel C reports the covariance between

and multiplied by a factor of -2.



FX 1 1.072 1.122 1.142 1.155 1.188

FX 2 1.036 1.075 1.101 1.088 1.106

FX 3 1.030 1.063 1.108 1.102 1.077

FX 4 1.050 1.087 1.116 1.114 1.091

FX 5 1.100 1.172 1.206 1.185 1.155



FX 1 0.153 0.166 0.140 0.130 0.140

FX 2 0.115 0.122 0.111 0.096 0.089

FX 3 0.112 0.101 0.116 0.103 0.076

FX 4 0.128 0.124 0.120 0.103 0.100

FX 5 0.168 0.166 0.159 0.147 0.112



FX 1 -0.225 -0.288 -0.282 -0.285 -0.328

FX 2 -0.151 -0.197 -0.212 -0.185 -0.195

FX 3 -0.142 -0.164 -0.224 -0.206 -0.153

FX 4 -0.178 -0.211 -0.236 -0.217 -0.191

FX 5 -0.268 -0.338 -0.365 -0.333 -0.266

23

Table IV

Variance Decomposition when the Predictive Variables are Realized Return, Return on Equity

(ROE), and the Relative Bill Rate

Table IV reports the variance decomposition results of unexpected returns of 25 double-sorted equal-

valued portfolios, using holding period stock returns including dividends, ROE (calculated using

Eisdorfer (2007) approach), and the relative bill rate, as the predictive variables. The variance

components are estimated as follows: , , and


and whose other elements are zero, and denote expected return news and cash flow news, is the

coefficient matrix of the following first order VAR system: , and is the

average ratio of the market price to the sum of the market price and the dividend, in this sample . Size 1 is

the portfolio that contains the smallest firms, Size 5 the largest firms (as measured by average market

capitalization). FX 1 contains firms with low Dimson-Gamma measures, i.e. firms that have a net short

foreign currency position, such as net importing firms, FX 3 contains firms with little equity FX

exposure, while FX 5 contains firms that have a net long foreign currency position, such as exporting

firms. Panel A, B and C report the portfolio averages of individual firm variance decompositions. Panel

A reports the variance of cash flow news as a percentage of the variance of unexpected stock returns

, Panel B shows the variance of expected return news as a percentage of the variance

of unexpected returns , and Panel C reports the covariance between

and multiplied by a factor of -2.



FX 1 1.144 1.253 1.184 1.133 1.107

FX 2 1.120 1.160 1.155 1.045 1.021

FX 3 1.104 1.125 1.134 1.051 0.965

FX 4 1.143 1.143 1.091 1.131 1.005

FX 5 1.139 1.206 1.262 1.175 1.096



FX 1 0.449 0.539 0.492 0.403 0.312

FX 2 0.363 0.398 0.383 0.290 0.297

FX 3 0.314 0.342 0.334 0.307 0.257

FX 4 0.351 0.351 0.337 0.349 0.247

FX 5 0.476 0.459 0.477 0.425 0.292



FX 1 -0.593 -0.792 -0.676 -0.536 -0.419

FX 2 -0.483 -0.558 -0.538 -0.335 -0.318

FX 3 -0.418 -0.467 -0.468 -0.357 -0.222

FX 4 -0.494 -0.494 -0.428 -0.480 -0.252

FX 5 -0.615 -0.665 -0.739 -0.600 -0.387

24

Table V

Regression Results Variance Decomposition based on Dividend Yield

Table V reports the regression analysis results of the relative importance of cash flow news for

internationally operating firms using variance decomposition results that included the holding period

return, the dividend yield, and the relative bill rate as predictive variables. Panel A reports the estimates

of regression 1: where the dependent variable is the variance of

cash flow news of firm as the percentage of the variance of unexpected stock returns of firm

, is the absolute value of the dimson gamma foreign currency exposure

measure of firm , and is the natural log of the average equity capitalization of firm . Panel B reports

the estimation results of regression 1 with the exception of only including Net importer firms, i.e. firms

that have a natural short FX position. Panel C repeats the analysis for Net exporting firms. Panel C reports

the results of the Chow test where states that there is no statistically significant difference between

Net importing and Net exporting firms.

Panel A

All Firms

Observations F-value p-value

11968 119.93 <.0001 0.0195

Variable Parameter Estimate t-statistic p-value

Intercept 0.85898 31.22 <.0001

Dimson Gamma 0.04883 15.01 <.0001

Log Firm Size 0.01463 6.13 <.0001

Panel B

Net Importing Firms


6673 51.69 <.0001 0.015


Intercept 0.84636 23.79 <.0001

Dimson-Gamma 0.04497 9.78 <.0001

Log Firm Size 0.01413 4.59 <.0001

Net Exporting Firms


5295 62.49 <.0001 0.0227


Intercept 0.89642 20.72 <.0001

Dimson-Gamma 0.05079 10.95 <.0001

Log Firm Size 0.0136 3.63 0.0003

Panel C

Chow Test

Degrees of Freedom Chow Test Statistic p-value

11964 17.2877 <.0001

25

Figure 1: Variance Decomposition using Returns, Dividend Yield and the Relative Bill Rate as the

Predictive Variables

Figure 1 shows the average portfolio values of the relative importance of cash flow news for individual firms

that are sorted into 25 double sorted equal valued portfolios. The variance decomposition used stock returns, dividend yield and the relative bill rate as predictive variables. The relative importance of cash flow news is

defined as the variance of cash flow news as a percentage of the variance of unexpected returns and depicted on the vertical axis. The horizontal axis show the five FX portfolio categories where 1 contains net importing firms, 3 low FX equity exposure firms, and 5 net exporting firms.

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Figure 2: Variance Decomposition using Returns, Net Payout and the Relative Bill Rate as the

Predictive Variables


that are sorted into 25 double sorted equal valued portfolios. The variance decomposition used stock returns, net payout and the relative bill rate as predictive variables. The relative importance of cash flow news is

defined as the variance of cash flow news as a percentage of the variance of unexpected returns and depicted on the vertical axis. The horizontal axis show the five FX portfolio categories where 1 contains net importing firms, 3 low FX equity exposure firms, and 5 net exporting firms.

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Figure 3: Variance Decomposition using Returns, ROE and the Relative Bill Rate as the Predictive

Variables


that are sorted into 25 double sorted equal valued portfolios. The variance decomposition used stock returns, ROE and the relative bill rate as predictive variables. The relative importance of cash flow news is defined as

the variance of cash flow news as a percentage of the variance of unexpected returns and depicted on the vertical axis. The horizontal axis show the five FX portfolio categories where 1 contains net importing firms, 3 low FX equity exposure firms, and 5 net exporting firms.

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Documents

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