How Big Is the Premium for Currency Risk

This paper examines the importance of exchange rate risk 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 should be conditional and show evidence of a significant return premium to firm-level currency exposures when conditioning on the exchange rate change. The return premium is directly related to the size and sign of the subsequent exchange rate change, suggesting fluctuations in exchange rates themselves as a source of time-variation in currency risk premia. For the entire sample the return premium ranges from 1.2 - 3.3% per unit of currency exposure. The premium is larger for firms in emerging markets, while in developed markets it is statistically significant only for local currency depreciations. Overall, the results indicate that exchange rate exposure plays an important role in generating cross-sectional return variation. Moreover, we show that the impact of exchange rate risk on stock returns is predominantly a cash flow effect as opposed to a discount rate effect.

Crossing the Lines: The Conditional Relation between Exchange Rate Exposure and Stock Returns in Emerging and Developed Markets

https://mpra.ub.uni-muenchen.de/14018/1/MPRA_paper_14018.pdf

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.

Foreign exchange risk pricing and equity market segmentation in Africa

A traditional Monte Carlo simulation using linear correlations induces estimation bias in measuring portfolio value-at-risk (VaR), due to the well-documented existence of fat-tail, skewness, truncations, and non-linear relations in return distributions. In this paper, we consider the above issues in modeling VaR and evaluate the effectiveness of using copula-extreme-value-based semiparametric approaches. To assess portfolio risk in six Asian markets, we incorporate a combination of extreme value theory (EVT) and various copulas to build joint distributions of returns. A backtesting analysis using a Monte Carlo VaR simulation suggests that the Clayton copula-EVT evinces the best performance regardless of the shapes of the return distributions, and that in general the copulas with the EVT provide better estimations of VaRs than the copulas with conventionally employed empirical distributions. These findings still hold in conditional-coverage-based backtesting. These findings indicate the economic significance of incorporating the down-side shock in risk management.

/pdf/effectiveness-of-copula-extreme-value-theory-in-estimating-1l3xqot78g.pdf

Effectiveness of copula-extreme value theory in estimating value-at-risk: empirical evidence from Asian emerging markets

We examine the relation between the cross-section of U.S. stock returns and foreign exchange rates during the period from 1973 to 2002. We find that stocks most sensitive to foreign exchange risk (in absolute value) have lower returns than others. This implies a non-linear, negative premium for foreign exchange risk. Sensitivity to foreign exchange generates a cross-sectional spread in stock returns unexplained by existing asset-pricing models. Consequently, we form a zero-investment factor related to foreign exchange sensitivity and show that it can reduce mean pricing errors for exchange-sensitive portfolios. One possible explanation for our findings includes Johnson's (2004) option-theoretic model in which expected returns are decreasing in idiosyncratic cashflow volatility.

Theodore C. Moorman

Papers

Foreign Exchange Risk and the Cross-Section of Stock Returns

Foreign exchange risk and the cross-section of stock returns