Asset pricing and foreign exchange risk

According to the International Capital Asset Pricing Model (ICAPM), the covariance of assets with foreign exchange currency returns should be a risk factor that must be priced when the purchasing power parity is violated. The goal of this study is to re-examine the relationship between stock returns and foreign exchange risk. The novelties of this work are: (a) a data set that makes use of daily observations for the measurement of the foreign exchange exposure and volatility of the sample firms and (b) data from a Eurozone country.The methodology we make use in reference to the estimation of the sensitivity of each stock to exchange rate movements is that it allows regressing stock returns against factors controlling for market risk, size, value, momentum, foreign exchange exposure and foreign exchange volatility. Stocks are then classified according to their foreign exchange sensitivity portfolios and the return of a hedge (zero-investment) portfolio is calculated. Next, the abnormal returns of the hedge portfolio are regressed against the return of the factors. Finally, we construct a foreign exchange risk factor in such manner as to obtain a monotonic relation between foreign exchange risk and expected returns.The empirical findings show that the foreign exchange risk is priced in the cross section of the German stock returns over the period 2000-2008. Furthermore, they show that the relationship between returns and foreign exchange sensitivity is nonlinear, but it takes an inverse U-shape and that foreign exchange sensitivity is larger for small size firms and value stocks.     

Exchange Rate Exposure at the Firm and Industry Level

Previous work on the exposure of firms to exchange rate risk has primarily focused on U.S. firms and, surprisingly, found stock returns were not significantly affected by exchange‐rate fluctuations. The equity market premium for exposure to currency risk was also found to be insignificant. In this paper we examine the relation between Japanese stock returns and unanticipated exchange‐rate changes for 1,079 firms traded on the Tokyo stock exchange over the 1975–1995 period. Second, we investigate whether exchange‐rate risk is priced in the Japanese equity market using both unconditional and conditional multifactor asset pricing testing procedures. We find a significant relation between contemporaneous stock returns and unanticipated yen fluctuations. The exposure effect on multinationals and high‐exporting firms, however, is found to be greater in comparison to low‐exporting and domestic firms. Lagged‐exchange rate changes on firm value are found to be statistically insignificant implying that investors are able to assess the impact of exchange‐rate changes on firm value with no significant delay. The industry level analysis corroborates the cross‐sectional findings for Japanese firms in that they are sensitive to contemporaneous unexpected exchange‐rate fluctuations. The co‐movement between stock returns and changes in the foreign value of the yen is found to be positively associated with the degree of the firm's foreign economic involvement and inversely related to its size and debt to asset ratio. Asset pricing tests show that currency risk is priced. We find corroborating evidence in support of the view that currency exposure is time varying. Our results indicate that the foreign exchange‐rate risk premium is a significant component of Japanese stock returns. The combined evidence from the currency exposure and asset pricing analyses, suggests that currency risk is priced and, therefoe, has implications for corporate and portfolio managers.     

Interest rates and risk premia in the stock market and in the foreign exchange market

This paper documents common empirical regularities in the foreign exchange market and in the US stock market. We find that increases in interest rates are associated with predictable increases in the volatility of returns in both markets, and that expected returns both in the stock market and in the foreign exchange market are negatively correlated with nominal interest rates.We show that not taking into account the time variation of second moments may seriously affect tests of asset pricing models. Using a numerical example based on the static capital asset pricing model, we are able to produce fluctuations in risk premia similar to those observed empirically. Finally we show that the overidentifying restrictions of the latent variable capital asset pricing model are not rejected when beats are assumed to be correlated with nominal interest rates.     

The impact of the introduction of the Euro on foreign exchange rate risk exposures

This paper tests whether significant changes in stock return volatility, market risk, and foreign exchange rate risk exposures took place around the launch of the Euro in 1999. The experiment analyzes weekly returns for 3220 nonfinancial firms from 18 European countries, the United States, and Japan. We find that though the Euro's launch was associated with an increase in total stock return volatility, significant reductions in market risk exposures arose for nonfinancial firms both in and outside of Europe. We show that the reductions in market risk were concentrated in firms domiciled in the Euro area and in non-Euro firms with a high fraction of foreign sales or assets in Europe. The Euro's introduction led to a net absolute decrease in the foreign exchange rate exposure of nonfinancial firms, but these changes are statistically and economically small. We interpret our findings in the context of existing theories of exchange rate risk management.     

Volatility and correlation in international stock markets and the role of exchange rate fluctuations

This paper develops a direct, explicit model for the role of exchange rate fluctuations in international stock markets and examines how and to what extent volatility and correlations in equity markets are influenced by exchange rate fluctuations. Evidence presented in this paper indicates that a higher foreign exchange rate variability mostly increases local stock market volatility but decreases volatility for the US stock market. The extent to which stock market volatility is influenced by foreign exchange variability is greater for local markets than for the US market, due to the fact that exchange rate changes are more strongly correlated with local equity market returns than the US market returns. We find that a higher exchange rate fluctuation marginally decreases the US/local equity market correlation. While exchange rate fluctuations held a relatively large fraction of the variation in local stock market returns, there was no significant influence on the US/local equity market correlation.     

International money and stock market contingent claims

We develop a unified approach with closed-form solutions for pricing bonds, stocks, currencies and their derivatives. The specification assumes a fundamental risk factor represented by a stochastic positive definite matrix following a Wishart autoregressive (WAR) process. By assuming a volatility-in-mean specification for the domestic stock returns and the relative changes of exchange rates, and a domestic stochastic discount factor exponential affine with respect to the fundamental risk, it is possible to derive closed form solutions for the term structures of interest rates and for the risk-neutral probabilities while keeping the flexibility of the model. In particular:

i) The domestic and foreign term structures are jointly affine and correspond to Wishart quadratic term structures, which can ensure the positivity of interest rates;

ii) In this framework where the stock price follows a model with stochastic volatility, we obtain explicit or quasi-explicit formulas for futures and forward contracts, swaps and options. This extends results by

Heston (1993)

and

Ball and Roma (1994)

.

Trading of foreign investors and stock returns in an emerging market - Evidence from Vietnam

This article investigates the impact of foreign investors' trading on stock returns in Vietnam, a key emerging market. We utilize a time series data set of foreign investors' trading volume and market returns of the Ho Chi Minh City stock exchange over an extended time frame before and after global financial crisis. The results indicate that foreign investors are positive feedback traders in Vietnam stock market. The findings also reveal the timing ability and trading strategy of foreign investors. The paper offers strong implications for market participants and portfolio investment.     

Exchange rate exposure and foreign exchange derivatives: do ineffective hedgers modify future derivatives use?

Recent studies examining the relationship between stock returns and exchange rate changes have provided evidence that the exchange rate exposure of non-financial companies is reduced by the use of foreign exchange derivatives. Building on such research, this study investigates whether past ineffective derivative hedging contributes to explaining future derivatives use. To the extent that companies monitor the effectiveness of their currency risk management practices, past ineffective hedgers can be expected to modify their future use of foreign exchange derivatives accordingly. In our study of 94 non-financial US multinationals, we provide evidence that the change in derivatives use from 1996–1998 to 1998–2000 can be explained in part by the ineffective hedging of currency risk in 1996–1998, controlling for variables associated with theories of optimal hedging. Additional analyses confirm that such primary results are robust to firm size, the level of foreign operations, and the use of derivatives to partially hedge currency risk. Our results imply that as exchange markets and risk management practices change, the use of derivatives to manage exchange rate risk also changes. Our contribution to this field of study is that we find evidence that past ineffective hedgers tend to increase their future use of FXDs.     

Exchange rates,interventions, and the predictability of stock returns in Japan

Using monthly Japanese data for the period 1991–2005, we examined the link between exchange rate movements and stock returns. We found that exchange rate movements per se do not help to explain stock returns. There is, however, evidence of in-sample predictability if one accounts for the interventions of the Japanese monetary authorities in the foreign exchange market. This evidence does not indicate a violation of market efficiency insofar as investors cannot use information on interventions to systematically improve the performance of simple trading rules based on out-of-sample forecasts of stock returns.     

Firm characteristics and the impact of emerging market liberalizations

We provide a firm level analysis of the impact of capital market liberalization in 18 emerging markets. Consistent with models of international asset pricing, we find that firms’ stock returns increase during liberalization and that a majority of firms have lower mean returns and lower dividend yields after liberalization. We also find that emerging market firms have increased exposure to the world market and decreased exposure to the home market following liberalization. These changes in returns and exposures support the predictions of theoretical international asset pricing models. We also test and find support for the importance of size, local risk, foreign exchange risk, and cross-listing status in explaining the cross-section of changes in returns.     

The exchange rate exposure of U.S. and Japanese banking institutions

In this paper, we examine the foreign exchange exposure of a sample of U.S. and Japanese banking firms. Using daily data, we construct estimates of the exchange rate sensitivity of the equity returns of the U.S. bank holding companies and compare them to those of the Japanese banks. We find that the stock returns of a significant fraction of the U.S. companies move with the exchange rate, while few of the Japanese returns that we observe do so. We next examine more closely the sensitivity of the U.S. firms by linking the U.S. estimates cross-sectionally to accounting-based measures of currency risk. We suggest that the sensitivity estimates can provide a benchmark for assessing the adequacy of existing accounting measures of currency risk. Benchmarked in this way, the reported measures that we examine appear to provide a significant, though only partial, picture of the exchange rate exposure of U.S. banking institutions. The cross-sectional evidence is also consistent with the use of foreign exchange contracts for the purpose of hedging.     

Foreign Exchange Volatility Is Priced in Equities

This paper finds that standard asset pricing models fail to explain the significantly negative delta hedging errors that occur as a result of the purchase of options on foreign exchange futures. Foreign exchange volatility does influence stock returns, however. The volatility of the JPY/USD exchange rate predicts the time series of stock returns and is priced in the cross‐section of stock returns.     

Do long-term swings in the dollar affect estimates of the risk premia?

Foreign exchange returns exhibit behavior difficult to reconcilewith standard theoretical models. This article asks whetherthe recent findings of long swings in exchange rates betweenappreciating and depreciating periods affect estimates of theforeign exchange risk premium. We demonstrate how the 'pesoproblem' introduced by expected shifts in exchange rate regimescan affect inferences about the risk premium in at least twoways: (1) it can make the foreign exchange risk premium appearto contain a permanent disturbance when it does not; and (2)it can induce bias in the foreign exchange return regressionssuch as in Fama (1984).     

Global liquidity risk in the foreign exchange market

Using a broad data set of 20 US dollar exchange rates and order flow of institutional investors over 14 years, we construct a measure of global liquidity risk in the foreign exchange (FX) market. Our FX liquidity measure may be seen as the analog of the well-known Pastor–Stambaugh liquidity measure for the US stock market. We show that this measure has reasonable properties, and that there is a strong common component in liquidity across currencies. Finally, we provide evidence that liquidity risk is priced in the cross-section of currency returns, and estimate the liquidity risk premium in the FX market around 4.7 percent per annum.     

Expected stock returns and volatility

This paper examines the relation between stock returns and stock market volatility. We find evidence that the expected market risk premium (the expected return on a stock portfolio minus the Treasury bill yield) is positively related to the predictable volatility of stock returns. There is also evidence that unexpected stock market returns are negatively related to the unexpected change in the volatility of stock returns. This negative relation provides indirect evidence of a positive relation between expected risk premiums and volatility.     

Stock market risk and return: an equilibrium approach

Empirical evidence that expected stock returns are weakly relatedto volatility at the market level appears to contradict theintuition that risk and return are positively related. We investigatethis issue in a general equilibrium exchange economy characterizedby a regime-switching consumption process with time-varyingtransition probabilities between regimes. When estimated usingconsumption data, the model generates a complex, non-linearand time-varying relation between expected returns and volatility,duplicating the salient features of the risk/return trade-offin the data. The results emphasize the importance of time-varyinginvestment opportunities and highlight the perils of relyingon intuition from static models.     

The Usefulness of Book-to-Market and ROE Expectations for Explaining UK Stock Returns

Abstract:  The fundamental valuation perspective on stock returns suggests that book-to-market will be positively related to returns if market value of equity equals future expected cash flows discounted at the expected return and book value proxies for future cash flows. Building on this perspective, we develop a log linear model which includes expectations of future BM and ROE in addition to current BM as explanatory variables for future stock returns. We show that these three variables explain a significant part of UK cross-sectional stock returns and that they remain highly statistically significant after including additional risk proxy variables. This supports relevance of fundamental valuation based firm characteristics for explaining stock returns and indicates their potential usefulness for predicting future stock returns.     

Foreign exchange volatility and stock returns

This paper explores whether foreign exchange volatility is a priced factor in the US stock market. Our investigation is motivated by a number of empirical as well as theoretical considerations. Empirically, Menkhoff et al. (2012) find that foreign exchange volatility is a pervasive factor across a variety of test assets. Theoretically, Shapiro (1974), Dumas (1978), and Levi (1990) imply that foreign exchange volatility can influence firms’ cash flow volatility therefore the discount rate. In terms of empirical implementation, we employ the cross-sectional regression methodology of Fama and MacBeth (1973) as well as the time-series regression approach of Fama and French (1996). For robustness, we also use the mimicking portfolio approach of Fama and French (1993). We find that foreign exchange volatility has no power to explain either the time-series or the cross-section of stock returns, which calls for more research on foreign exchange risk. Bartov et al. (1996) and Adrian and Rosenberg (2008) suggest an alternative and maybe promising direction.     

Asset pricing in China's domestic stock markets: Is there a logic?

China's stock markets have grown rapidly since their inception and have become an increasingly important emerging market for international investors. However, there are few systematic studies on how asset prices are formed in Chinese domestic equity markets; popular financial media even depict the market as irrational. In this paper, we study the asset pricing mechanism in the nascent Chinese stock markets, with the objective of identifying variables that capture the cross-sectional variation in average stock returns. We focus on the effects of various market imperfections in China. We find that while the market risk (beta) is not priced, there is a significantly negative relationship between firm-specific risk and expected returns. Chinese investors are willing to pay a significant premium for more liquid stocks or for dividend-paying stocks. Furthermore, investors value local A-shares more if there are offshore counterparts (e.g., B- and H-shares) for foreigners, implying that a Chinese firm with a foreign shareholder base has a lower cost of capital, ceteris paribus. Lastly, as with U.S. and other mature markets, firm size and the book-to-market ratio are systematically related to stock returns. Given market imperfections, stocks are priced rather rationally in China, despite the widespread perception to the contrary.     

STOCK RETURNS AND VOLATILITY ON CHINA'S STOCK MARKETS

We examine time‐series features of stock returns and volatility, as well as the relation between return and volatility in four of China's stock exchanges. Variance ratio tests reject the hypothesis that stock returns follow a random walk. We find evidence of long memory of returns. Application of GARCH and EGARCH models provides strong evidence of time‐varying volatility and shows volatility is highly persistent and predictable. The results of GARCH‐M do not show any relation between expected returns and expected risk. Daily trading volume used as a proxy for information arrival time has no significant explanatory power for the conditional volatility of daily returns. JEL classification: G15