Asymmetric currency exposure and currency risk pricing

Whether stock returns are linked to currency movements and whether currency risk is priced in a domestic context are less conclusive and thus still subject to a great debate. Based on a different approach, this paper attempts to provide new empirical evidence on these two inter-related issues, which are critical to investors and corporate risk management. In particular, this paper not only explores the possibility of asymmetric currency exposure that may explain why prior studies, which focus exclusively on linear exposure, have difficulty in detecting it, but also tests whether this asymmetric currency exposure is priced. The results show strong evidence of asymmetric currency exposure and currency risk pricing, suggesting that both asymmetry and conditional heteroskedasticity play important roles in testing currency exposure and its price.     

A re-examination of exposure to exchange rate risk: The impact of earnings management and currency derivative usage

In an attempt to explain the weak evidence of priced exchange rate risk, we hypothesize that in addition to currency derivative usages, earnings management serves as another factor contributing to a reduction in exchange rate exposure. Our evidence reveals that earnings management activities, particularly those undertaken for the purpose of income smoothing, significantly reduce firm-specific exchange rate exposure, and that such role is particularly important if appropriate currency derivative instruments are limited. These results complement prior attempts to explain the puzzle of unpriced exchange rate risk. The investigation also highlights the importance of recognizing different managerial purposes behind discretionary accruals.     

The risk implications of insurance securitization: The case of catastrophe bonds

Catastrophe (Cat) bonds are insurance securitization vehicles which are supposed to transfer catastrophe-related underwriting risk from issuers to capital markets. This paper addresses key, unanswered questions concerning Cat bonds and offers the following results. First, our findings show firms that issue Cat bonds exhibit less risky underwriting portfolios with less exposure to catastrophe risks and overall less need to hedge catastrophe risk. These results show that the access to the market for insurance securitization is easiest for firms with less risky portfolios. Second, firms that issue Cat bonds are found to experience a reduction in their default risk relative to non-issuing firms and our results, therefore, demonstrate that Cat bonds provide effective catastrophe hedging for issuing firms. Third, firms with less catastrophe exposure, increase their catastrophe exposure following an issue. Therefore, our paper cautions that the ability to hedge catastrophe risk causes some firms to seek additional catastrophe risk.     

The reinvestment risk premium in the valuation of British and Russian government bonds

This article studies the dynamic properties of the reinvestment risk premium in the UK and RF government bond markets. In a new interest rate environment when sovereign debt trades at a low and even negative yields and bond funds are struggling to earn sufficient returns, bond investors have become increasingly wary of reinvestment risk largely neglected previously. The reinvestment risk premium is quantified on the basis of replicating portfolios and further analyzed with respect to exposure to exogenous influence with the help of cointegration techniques. The findings are that in both markets investors recognize the significance of reinvestment risk. However, there are differences in the sensitivity of the reinvestment risk premium to exogenous indicators. In the UK government bond market investors tend to be guided by more conservative indicators but are ready to forecast in the medium-run; in the RF government bond market investors tend to be guided by less conservative indicators but are ready to forecast only in the short-run.     

The allocation of catastrophe risk

The potential losses from catastrophes have led financial researchers to address the following questions: (1) to what extent is catastrophe risk being shared (insured) and is the allocation of catastrophe risk consistent with notions of optimal risk sharing? (2) if not, what market imperfections hinder the efficient allocation of catastrophe risk? and (3) are there government policies or private market solutions that could lead to a more efficient allocation of catastrophe risk? This paper summarizes the research that has been conducted on these questions.     

Measuring currency exposure with quantile regression

In this paper, we explore an alternative explanation of the exposure puzzle, the missing variable bias in previous studies. We propose to correct the bias with the quantile regression technique invented by Koenker and Bassett (Econometrica 46:33–51, 1978). Empirically, as soon as we take into account the missing variable bias as well as time variation in currency exposure, we find that 26 out of 30 or 87 % of the US industry portfolios exhibit significant currency exposure to the Major Currencies Index, and 23 out of 30 or 77 % show significant exposure to the Other Important Trading Partners Index. Our results have important theoretical and practical implications. In terms of theoretical significance, our results strengthen the findings in Francis et al. (J Financ Econ 90:169–196, 2008), and suggest that methodological weakness, not hedging, may explain the insignificance of currency risk in previous studies. In terms of practical significance, our results suggest a simple yet efficient approach for managers to estimate currency exposure of their firms.     

GDP growth and currency valuation: The case of the dollar

One popular view on the strength of the US dollar around the turn of the century is that the higher growth in the US compared to Europe had stimulated foreigners to buy American assets, thereby driving up the exchange rate. In this paper a modified portfolio balance model is presented, in which it is shown that the impact of output growth on the exchange rate depends crucially on the origin of this growth. An improvement of the output gap is shown to actually depress the exchange rate whereas an increase in potential output growth leads to an appreciation, especially if this improvement is likely to be persistent. In an empirical example, it is shown that the equilibrium real dollar rate is indeed positively affected by high trend growth in the US, whereas it is negatively affected by a positive output gap. The model outperforms the random walk in forecasting future real dollar rates one to eight quarters ahead.     

Fundamentals of corporate currency exposure

I model the relation between corporate currency exposure and fundamental variables like demand elasticities and operating cost structure. The currency location of a firm's operating costs may be in the home currency, the foreign currency, or partially in each. I start with a single-firm setting and extend the results to a competitive setting. The model should help managers better understand the determinants of currency exposure and thus better perform the important tasks of strategic planning and managing enterprise risk.     

The pricing of currency risk in Japan

Previous work on the pricing of exchange-rate risk has primarily focused on US firms and, surprisingly, found stock returns were not significantly affected by exchange-rate fluctuations. In this paper we conduct an in-depth investigation that examines whether exchange-rate risk is priced in the equity market of Japan using an intertemporal asset pricing testing procedure that allows risk premia to change through time in response to changes in macroeconomic conditions. Our multiperiod asset pricing tests show that the foreign exchange-rate risk premium is a significant component of Japanese stock returns. Specifically, the results suggest that currency-risk exposure commands a significant risk premium for multinationals and high-exporting Japanese firms. The currency-risk factor is found to be less influential in explaining the behavior of average returns for low-exporting and domestic firms. However, it is shown to exhibit large return volatility that is likely to be perceived by investors, who wish to control portfolio risk, as an important underlying source of risk. Furthermore, Japanese stock returns are found to be related to the relative distress and size factors above and beyond the covariation explained by the currency-risk factor.     

Internationalization,foreign exchange exposure and firm risk

This paper examines the effect of internationalization on variation in operating performance. Analyzing a sample of non-financial firms in Switzerland during 2000–2020, we document two key findings. First, internationalization is positively associated with variation in operating performance. However, neither operational-hedging internationalization nor revenue-seeking internationalization moderates the relation between internationalization and variation in operating performance. Second, our findings show that the unhedged foreign exchange exposure neither strengthens nor weakens the effect of internationalization on variation in operating performance. Further analyses show that internationalization is not associated with firm performance.     

Foreign exchange risk exposure: Survey and suggestions

Assessing the sensitivity of firm value to exchange rate changes has been one of the most challenging issues in international financial management over the last two decades. This paper reviews the rapidly growing exchange exposure literature, with particular reference to recent developments. The studies reviewed focus on two primary areas of inquiry: the theoretical foundations of exchange risk exposure and the empirical evidence on the link between stock returns and currency fluctuations. Although much has been learned in each field, this survey highlights the areas of research in which our understanding of the mechanism of exchange exposure is still incomplete.     

Exposure to currency risk by US multinational corporations

Despite evidence that large US multinational corporations are hedging their exchange rate risk exposure, existing literature on the measurement of exchange rate risk does not give us a tool to measure the effect of such hedging activities of multinational firms. This paper revisited the measurement of exchange rate risk exposure using the cumulative translation adjustment as a trade-weighted dollar index faced by individual companies. We find that especially small multinational firms are exposed to foreign exchange risk and benefit from a weakening in the international value of the US dollar. The results also indicate that hedging activities by large firms are not so effective to eliminate exchange risk. Two industries in particular show a highly significant relation between changes in the cumulative translation account and equity returns, however, with an opposite sign, i.e. positive for electrical equipment and negative for primary metals.     

The valuation of nonsystematic risks and the pricing of Swedish lottery bonds

Swedish government lottery bonds have coupon payments determinedby lottery. They offer a unique opportunity to study a securitywith uncertain payoffs having a known, observable distribution.The risk associated with the lotteries is idiosyncratic by constructionand should not command a risk premium in equilibrium. The bondsare traded in two forms, allowing us to evaluate the rewardsto bearing extra lottery risk. Despite its idiosyncratic nature,we find prices appear to reflect aversion to this risk. We evaluatethe empirical determinants of this differential pricing andpossible explanations for it.     

The currency risk factor in international equity pricing

Currency risk in the pricing of international equity returns is analyzed from an empirical viewpoint. The significance of the domestic market index, and the world index is also analyzed. The methodology is based on the Asymptotic Principal Components when an approximate factor structure is assumed. Monthly stock price returns for five countries are used. Thirty stocks are chosen from each country. Fifteen years of data is used. The U.S. Dollar is the numeraire. Exchange risk is generally not priced. The Domestic market index is always priced. The pricing of the World Index is mixed, i.e., it is priced in certain case and not in others.     

Hedging bonds subject to credit risk

This paper provides a simple and practical approach to hedging bonds that are subject to credit risk. Three new hedge ratios are derived and tested and the roles of basis risk and diversification is investigated. Empirical tests reveal that basis risk is an important factor in hedging corporate bonds. These tests identify a need for new interest rate derivatives where the underlying asset is subject to credit risk.     

Volatility changes in European currency exchange rates due to EMS announcements

This study examines the effects of announcements concerning European Monetary Union on the exchange rate volatilities of several European currencies. It is expected that when good news is portrayed in regard to a single currency this will be considered bad news, thus eliciting a negative reaction, for the German mark. Conversely, good news for a single currency should also be good news for weaker currencies, such as the Portuguese escudo, the Italian lira, the Greek drachma, and the Spanish peseta. In terms of volatility, a reaction to good news should be a reduction in volatility, as bad news should cause an increase in volatility. In total there are 22 announcements examined from January 1986 through September 1997. The German mark is observed to experience greater increases in volatility than decreases, as does the Italian lira. Portugal and Greece appear to react more strongly to positive news in that the decreases in volatility are on average greater than the increases.     

The market for catastrophe risk: a clinical examination

This paper examines the market for catastrophe event risk – i.e., financial claims that are linked to losses associated with natural hazards, such as hurricanes and earthquakes. Risk management theory suggests protection by insurers and other corporations against the largest cat events is most valuable. However, most insurers purchase relatively little cat reinsurance against large events, and premiums are high relative to expected losses. To understand why the theory fails, we examine transactions that look to capital markets, rather than traditional reinsurance markets, for risk-bearing capacity. We develop eight theoretical explanations and find the most compelling to be supply restrictions associated with capital market imperfections and market power exerted by traditional reinsurers.     

Implied tax rates and the valuation of discount bonds

Discount bonds afford the investor the opportunity for capital gains. If for tax reasons the market is segmented on the demand side, investors in lower and lower tax brackets must be attracted when interest rates rise and the supply of discount bonds increases. Changes in the differential tax on capital gains and interest income also should affect relative demand. Testing these hypotheses with U.S. Treasury bond data, the implied tax rate is found to vary over time in a manner consistent with market segmentation and tax law changes.