Exchange Rate Uncertainty and Firm Profitability

This paper investigates the effects of permanent and transitory components of the exchange rate on firms' profitability under imperfect information. Utilizing a signal extraction framework, we show that the variances of these components of the exchange rate process will have indeterminate effects on the firm's growth rate of profits, but will have predictable effects on its volatility. An increase in the variance of the permanent (transitory) component in the exchange rate process leads to greater (lesser) variability in the growth rate of the firm's profits, thus establishing that the source of exchange rate volatility matters in analyzing its effects. Implications of our theoretical findings for the empirical modeling of the underlying relationships are discussed.