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.     

International portfolio diversification is better than you think

Using aggregate data on bilateral cross-border equity holdings, we investigate whether investors correctly hedge their over-exposure to domestic risk (the well-known equity home bias) by investing in foreign stock markets that have low correlation with their home stock market. To deal with the endogeneity of stock return correlations, we instrument current correlations with past correlations. Controlling for many determinants of international portfolios, we find that, all else equal, investors do tilt their foreign holdings towards countries, which offer better diversification opportunities. The diversification motive that we uncover is stronger for source countries exhibiting a higher level of home bias.     

Foreign participation in local currency bond markets

Countries that cannot attract foreigners to invest in their local currency bonds run the risk of currency mismatches that can result in painful crises. We analyze foreign participation in the bond markets of over 40 countries. Bond markets in less developed countries have returns characterized by high variance and negative skewness, factors that we show are eschewed by U.S. investors. While results based on a three-moment CAPM indicate that it is diversifiable idiosyncratic risk that U.S. investors shun, our analysis suggests that countries can improve foreign participation by reducing macroeconomic instability.     

Foreign exchange risk pricing and equity market segmentation in Africa

This work is the first to investigate simultaneously the occurrence of unconditional currency risk pricing and equity market segmentation in Africa’s major stock markets. The multi-factor asset pricing theory provides the theoretical framework for our model. We find strong evidence suggesting that Africa’s equity markets are partially segmented. However, we find insufficient evidence to reject the hypothesis that foreign exchange risk is not unconditionally priced in Africa’s stock markets. This result is robust to alternative foreign exchange rate-adjusted return measures. These findings suggest that international investors can diversify into Africa’s equity markets without worrying about unconditional risks associated with foreign exchange rate fluctuations.     

The risk adjusted uncovered equity parity

This paper explores the risk adjusted uncovered equity parity model to investigate a degree of market integration for four Asian emerging markets relative to the U.S., Japan and the U.K. from January 1994 to July 2008. The uncovered equity parity is revised to take into account of market risk in a framework of a portfolio rebalancing model. Evidence was found to strongly support our hypotheses; Market risk is significant in international capital flows between the Asian emerging markets and the developed economies, and it can help explain the failure of a traditional uncovered equity (or interest) parity model. The relationship between returns and an appreciation of the exchange rate are divided between the Asian emerging markets and the developed economies, depending on the direction of capital flows.     

Forecasting Emerging Market Exchange Rates from Foreign Equity Options

The use of derivatives to infer future exchange rates has long been a subject of interest in the international finance literature. With the recent currency crises in Mexico, Southeast Asia, and Brazil, work on exchange rate expectations in emerging markets is of particular interest. For some emerging markets, foreign equity options are the only liquid exchange‐traded derivatives with currency information embedded in their prices. Given that emerging markets sometimes undergo currency realignment with discrete jumps in their exchange rate, estimation of risk‐neutral probability density functions from foreign equity option data provides valuable evidence concerning market expectations. To illustrate the use of foreign equity options in estimating market beliefs, we consider Telmex options around the 1994 peso devaluation and find evidence that markets anticipated the change in the Mexican government's foreign exchange policy.     

Countercyclical currency risk premia

We describe a novel currency investment strategy, the ‘dollar carry trade,’ which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the U.S. price of risk is high. The countercyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon. The estimated model implies that the variation in the exposure of U.S. investors to worldwide risk is the key driver of predictability.     

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.     

iShares Australia: a clinical study in international behavioral finance

Using iShares Australia returns as a proxy for the influence of overseas investors in the Australian market, we found that U.S.-based investors in the Australian market overreact to contemporaneous and lagged returns of the U.S. equity market, the U.S.-Australian dollar exchange rate, and past iShares Australia returns. In response to changing conditional risk, however, investors behave rationally: increasing (decreasing) expected risk is associated with falling (rising) prices. In light of these findings, we hypothesize that behavioral finance might explain the observed correlations between international equity markets.     

Domestic and foreign country bias in international equity portfolios

Distinguishing two components of the preference for geographical proximity – the domestic country bias assessing investors’ holdings within the domestic market, and the foreign country bias assessing investors’ bilateral holdings within a particular host, I document a number of stylized facts related to international equity portfolios. First, investors in emerging countries hold systematically larger shares in their local markets compared to investors in developed countries. Second, while investors generally allocate trivial shares to most of the available destinations and completely disregard the remaining ones, I report several positive country bias ratios suggesting that the source country's investors overweigh the destination market. Third, the portfolio equity held in only a small number of destination markets generates much of countries’ existing foreign assets. I refer to this observation as the geographical shrinkage suggesting that the domestic bias coexists with an equally imperfect diversification of investors’ foreign asset holdings.     

DO FOREIGN INVESTORS PRICE FOREIGN EXCHANGE RISK DIFFERENTLY?

We test whether foreign investors price foreign exchange risk differently from local investors. Drawing from the closed‐end country fund literature, we argue that both differential access to information by foreign versus local investors and different sources of exchange risk that investors face (economic or translation exposure) will lead to different pricing of the exchange risk associated with American Depositary Receipt (ADR) investments. We apply a two‐step method to country portfolios of ADRs of Australia, France, Japan, and the United Kingdom traded on the New York Stock Exchange. Our results show that foreign investors generally price exchange risk differently from local investors, and that the source and magnitude of differences in exchange risk pricing vary significantly across countries. Although significant differences in pricing exchange risk between foreign and local investors are observed for Australia, France, and Japan, no such pricing difference is noticed for the United Kingdom. Furthermore, the pricing differences observed for Australian and French ADRs are mainly attributed to the exchange risk of underlying share returns (economic exposure), whereas the pricing differences for Japanese ADRs are mainly attributed to the exchange risk associated with currency translation (translation exposure). We offer some explanations for our findings.     

SYMMETRIC VERSUS ASYMMETRIC CONDITIONAL COVARIANCE FORECASTS: DOES IT PAY TO SWITCH?

Volatilities and correlations for equity markets rise more after negative returns shocks than after positive shocks. Allowing for these asymmetries in covariance forecasts decreases mean‐variance portfolio risk and improves investor welfare. We compute optimal weights for international equity portfolios using predictions from asymmetric covariance forecasting models and a spectrum of expected returns. Investors who are moderately risk averse, have longer rebalancing horizons, and hold U.S. equities benefit most and may be willing to pay around 100 basis points annually to switch from symmetric to asymmetric forecasts. Accounting for asymmetry in both variances and correlations significantly lowers realized portfolio risk.     

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.     

Foreign investment with inflation-linked securities: A natural hedge under Fisher theory?

All foreign holders of U.S. dollars currencies face significant risk of unfavorable currency exchange movements, proportional to the amounts they hold. Some of these risks can be hedged to an extent, but the costs of doing so can be significant, and errors in execution or maintenance of the hedges can cause serious capital losses. Today the vast holdings of China and others creates currency risk on an unprecedented scale. China alone now has a total in excess of a trillion (1 × 10¹²) U.S. dollars, which makes traditional approaches to hedging problematic at best.¹ This paper analyzes the potential hedging effectiveness of investing foreign dollar holdings in U.S. inflation-indexed securities under Fisher's Identity. To the extent that Fisher's Identity and its derivative theories hold, foreign investors can effectively protect the purchasing power of their dollar balances, and earn an assured rate of return. Investment in inflation-indexed securities does not incur the additional expenses that swaps and currency hedges do.     

Global Currency Hedging

Over the period 1975 to 2005, the U.S. dollar (particularly in relation to the Canadian dollar), the euro, and the Swiss franc (particularly in the second half of the period) moved against world equity markets. Thus, these currencies should be attractive to risk-minimizing global equity investors despite their low average returns. The risk-minimizing currency strategy for a global bond investor is close to a full currency hedge, with a modest long position in the U.S. dollar. There is little evidence that risk-minimizing investors should adjust their currency positions in response to movements in interest differentials.     

Crossing the lines: The conditional relation between exchange rate exposure and stock returns in emerging and developed markets

This paper examines the importance of exchange rate exposure in the return generating process for a large sample of non-financial firms from 37 countries. We argue that the effect of exchange rate exposure on stock returns is conditional and show evidence of a significant return impact to firm-level currency exposures when conditioning on the exchange rate change. We further show that the realized return to exposure is directly related to the size and sign of the exchange rate change, suggesting fluctuations in exchange rates as a source of time-variation in currency return premia. For the entire sample the return impact ranges from 1.2 to 3.3% per unit of currency exposure, and it is larger for firms in emerging markets compared to developed markets. Overall, the results indicate that foreign exchange rate exposure estimates are economically meaningful, despite the fact that individual time-series results are noisy and many exposures are not statistically significant, and that exchange rate exposure plays an important role in generating cross-sectional return variation. Moreover, we show that the relation between exchange rate exposure and stock returns is more consistent with a cash flow effect than a discount rate effect.     

When bonds matter: Home bias in goods and assets

This paper presents a model of international portfolios with real exchange rate and non-financial risks that account for observed levels of equity home bias. Bonds matter: in equilibrium, investors structure their bond portfolio to hedge real exchange rate risks. Equity home bias arises when non-financial income risk is negatively correlated with equity returns, after controlling for bond returns. Our framework allows us to derive equilibrium bond and equity portfolios in terms of directly measurable hedge ratios. An empirical application to G-7 countries finds strong empirical support for the theory. We are able to account for a significant share of the equity home bias and obtain an aggregate currency exposure of bond portfolios comparable to the data.     

Asymmetric foreign exchange risk exposure: Evidence from U.S. multinational firms

This paper examines how U.S. multinational firms are affected by foreign currency movements. In light of detailed exchange rate data, we find that 29% of our sample of 935 U.S. firms with real operations in foreign countries is significantly affected by currency movements between 1990 and 2001. Results show moreover that U.S. stock returns react asymmetrically to currency movements. By introducing nonlinearity in foreign currency risk exposure, we noticeably increase the precision and the significance of exposure estimates. We demonstrate moreover that asymmetries are more pronounced towards large versus small currency fluctuations than over depreciation and appreciation cycles.     

Exchange rate and inflation risk premia in the EMU

This paper tests the effects of exchange rate and inflation risk factors on asset pricing in the European Union (EU) stock markets. This investigation was motivated by the results of Vassalou [J. Int. Money Finance, 2000, 19, 433–470] showing that both exchange rate and foreign inflation are generally priced in equity returns, and it studies the opportunity of evaluating the causality between these sources of risk after the elimination of the EU currency risks because of the adoption of the single currency. Our results show that both exchange rate and inflation risks are significantly priced in the pre- and post-euro periods. Moreover, the sizes of exchange rate and inflation risk premiums are economically significant in the pre- and post-euro periods. Futhermore, the UK and excluding-UK inflation risk premiums explain, in part, our evidence concerning a large EUR/GBP exchange rate risk premium and the existence of an economically significant domestic non-diversifiable risk after euro adoption. Hence overlooking inflation risk factors can produce an under/overestimation of the currency premiums and a miscalculation of the degree of integration of stock markets.