Foreign Exchange Risk and the Cross-Section of Stock Returns

doi:10.2139/SSRN.686509

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Foreign Exchange Risk and the Cross-Section of Stock Returns

Journal Article•DOI•

Foreign Exchange Risk and the Cross-Section of Stock Returns

James W. Kolari¹, Theodore C. Moorman², Sorin M. Sorescu¹•Institutions (2)

Texas A&M University¹, Northern Illinois University²

13 Jul 2007-Social Science Research Network-

TL;DR: The authors examined the relation between the cross-section of U.S. stock returns and foreign exchange rates during the period from 1973 to 2002 and found that stocks most sensitive to foreign exchange risk have lower returns than others.

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Abstract: 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.

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Journal Article•DOI•

How Big Is the Premium for Currency Risk

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William H. Sackley

01 May 1999-Cfa Digest

292 citations

Posted Content•

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

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Söhnke M. Bartram¹, Gordon M. Bodnar²•Institutions (2)

University of Warwick¹, Johns Hopkins University²

02 Nov 2008-Research Papers in Economics

TL;DR: In this article, the authors examined the importance of exchange rate risk in the return generating process for a large sample of non-financial firms from 37 countries and showed 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.

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Abstract: 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.

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102 citations

Journal Article•DOI•

Foreign exchange risk pricing and equity market segmentation in Africa

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Odongo Kodongo¹, Odongo Kodongo², Kalu Ojah²•Institutions (2)

Jomo Kenyatta University of Agriculture and Technology¹, University of the Witwatersrand²

01 Sep 2011-Journal of Banking and Finance

TL;DR: In this paper, the authors investigate the occurrence of unconditional currency risk pricing and equity market segmentation in Africa's major stock markets and find strong evidence suggesting that Africa's equity markets are partially segmented.

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Abstract: 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.

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55 citations

Cites background from "Foreign Exchange Risk and the Cross..."

...See Dumas and Solnik (1995), De Santis and Gerard (1998), Doukas et al. (1999), MacDonald (2000), Kolari et al. (2008) and Cappiello and Panigirtzoglou (2008)....
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Journal Article•DOI•

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

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Chun-Pin Hsu¹, Chin-Wen Huang², Wan-Jiun Paul Chiou³•Institutions (3)

City University of New York¹, Western Connecticut State University², Shippensburg University of Pennsylvania³

18 Apr 2012-Review of Quantitative Finance and Accounting

TL;DR: In this article, a combination of extreme value theory (EVT) and various copulas is used to build joint distributions of returns for portfolio risk assessment in six Asian markets, and 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.

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Abstract: 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.

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53 citations

Cites background from "Foreign Exchange Risk and the Cross..."

...However, recent studies (e.g., Ang and Chen, 2002; Boyer, Gibson, and Loretan, 1999; Kolari, Moorman, and Sorescu, 2008; Longin and Solnik, 2001; and Tastan, 2006) have shown that return correlations among assets are non-linear and time-varying....
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...Kolari, Moorman, and Sorescu (2008) find that firms that are highly sensitive to foreign exchange rate exposure tend to have low stock returns....
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...Ang and Chen (2002); Boyer, Gibson, and Mico (1999); Kolari, Moorman, and Sorescu (2008); Longin and Solnik, (2001); and Tastan (2006) suggest that correlation based on the normal distribution may generate misleading results in portfolio risk management....
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Journal Article•DOI•

Exchange rate risk and the equity performance of financial intermediaries

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Dimitrios Gounopoulos¹, Philip Molyneux², Sotiris K. Staikouras³, Sotiris K. Staikouras⁴, John O. S. Wilson⁵, Gang Zhao⁶ - Show less +2 more•Institutions (6)

University of Surrey¹, Bangor University², City University London³, ALBA Graduate Business School⁴, University of St Andrews⁵, University of Bath⁶

01 Sep 2013-International Review of Financial Analysis

TL;DR: In this article, the authors used the VAR-BEKK methodology to examine the relationship between equity returns and currency exposure for a sample of U.S., U.K. and Japanese banks and insurance firms during 2003-2011.

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36 citations

Cites background or methods from "Foreign Exchange Risk and the Cross..."

...Unlike previous studies, Kolari et al. (2008) and Choi and Jiang (2009) adopt an alternative specification by adding the home currency changes to the Fama and French (1993) model to evaluate currency exposure....
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...This view is questioned, by Choi and Jiang (2009) who claim that the currency exposure of internationally oriented firms, operating in the U.S. during currency exposure refers to the changes of the USD against another currency (all five currencies)....
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References

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Journal Article•DOI•

The Pricing of Options and Corporate Liabilities

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Fischer Black, Myron S. Scholes

01 May 1973-Journal of Political Economy

TL;DR: In this paper, a theoretical valuation formula for options is derived, based on the assumption that options are correctly priced in the market and it should not be possible to make sure profits by creating portfolios of long and short positions in options and their underlying stocks.

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Abstract: If options are correctly priced in the market, it should not be possible to make sure profits by creating portfolios of long and short positions in options and their underlying stocks. Using this principle, a theoretical valuation formula for options is derived. Since almost all corporate liabilities can be viewed as combinations of options, the formula and the analysis that led to it are also applicable to corporate liabilities such as common stock, corporate bonds, and warrants. In particular, the formula can be used to derive the discount that should be applied to a corporate bond because of the possibility of default.

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28,434 citations

"Foreign Exchange Risk and the Cross..." refers background in this paper

...In the Black and Scholes (1973) model, an increase in underlying volatility results in a decrease of the call option’s expected rate of return, and this effect is stronger for options that are near the money....
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Journal Article•DOI•

Common risk factors in the returns on stocks and bonds

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Eugene F. Fama¹, Kenneth R. French¹•Institutions (1)

University of Chicago¹

01 Feb 1993-Journal of Financial Economics

TL;DR: In this article, the authors identify five common risk factors in the returns on stocks and bonds, including three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity.

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24,874 citations

"Foreign Exchange Risk and the Cross..." refers background or methods or result in this paper

...13 If XMI is a priced factor, it should reduce the mean pricing error (absolute value of the intercept) of the other pricing models examined (i.e., ICAPM, three-factor, and four-factor), consistent with the argument of Fama and French (1993)....
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...Fama and French (1993) show that their model cannot properly price these stocks, but we find that the magnitude of their intercept is cut in half with the inclusion of XMI; however, the intercept remains significant at the ten percent level....
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...15 Our cross-sectional tests are similar in spirit to the size and book-to-market tests conducted by Fama and French (1992), while our time series tests most closely resemble those of Fama and French (1993)....
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...These forex-sensitive stocks tend to be small firms in financial distress, the type of firms that would normally command higher than average expected returns based on the findings of Fama and French (1992, 1993)....
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...Book equity is computed from COMPUSTAT as defined in Fama and French (1993) and is measured for the fiscal year ending in calendar year t-1....
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Report•DOI•

A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix

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Whitney K. Newey, Kenneth D. West

01 May 1987-Econometrica

TL;DR: In this article, a simple method of calculating a heteroskedasticity and autocorrelation consistent covariance matrix that is positive semi-definite by construction is described.

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Abstract: This paper describes a simple method of calculating a heteroskedasticity and autocorrelation consistent covariance matrix that is positive semi-definite by construction. It also establishes consistency of the estimated covariance matrix under fairly general conditions.

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18,117 citations

"Foreign Exchange Risk and the Cross..." refers methods in this paper

...Similar to Starks and Wei (2005) and Doidge, Griffin and Williamson (2006), we construct a number of firm-level measures of foreign business activity and financial condition....
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Journal Article•DOI•

The Cross‐Section of Expected Stock Returns

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Eugene F. Fama, Kenneth R. French

01 Jun 1992-Journal of Finance

TL;DR: In this paper, Bhandari et al. found that the relationship between market/3 and average return is flat, even when 3 is the only explanatory variable, and when the tests allow for variation in 3 that is unrelated to size.

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Abstract: Two easily measured variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with market 3, size, leverage, book-to-market equity, and earnings-price ratios. Moreover, when the tests allow for variation in 3 that is unrelated to size, the relation between market /3 and average return is flat, even when 3 is the only explanatory variable. THE ASSET-PRICING MODEL OF Sharpe (1964), Lintner (1965), and Black (1972) has long shaped the way academics and practitioners think about average returns and risk. The central prediction of the model is that the market portfolio of invested wealth is mean-variance efficient in the sense of Markowitz (1959). The efficiency of the market portfolio implies that (a) expected returns on securities are a positive linear function of their market O3s (the slope in the regression of a security's return on the market's return), and (b) market O3s suffice to describe the cross-section of expected returns. There are several empirical contradictions of the Sharpe-Lintner-Black (SLB) model. The most prominent is the size effect of Banz (1981). He finds that market equity, ME (a stock's price times shares outstanding), adds to the explanation of the cross-section of average returns provided by market Os. Average returns on small (low ME) stocks are too high given their f estimates, and average returns on large stocks are too low. Another contradiction of the SLB model is the positive relation between leverage and average return documented by Bhandari (1988). It is plausible that leverage is associated with risk and expected return, but in the SLB model, leverage risk should be captured by market S. Bhandari finds, howev er, that leverage helps explain the cross-section of average stock returns in tests that include size (ME) as well as A. Stattman (1980) and Rosenberg, Reid, and Lanstein (1985) find that average returns on U.S. stocks are positively related to the ratio of a firm's book value of common equity, BE, to its market value, ME. Chan, Hamao, and Lakonishok (1991) find that book-to-market equity, BE/ME, also has a strong role in explaining the cross-section of average returns on Japanese stocks.

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14,517 citations

Journal Article•DOI•

Risk, Return, and Equilibrium: Empirical Tests

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Eugene F. Fama, James D. MacBeth

01 May 1973-Journal of Political Economy

TL;DR: In this article, the relationship between average return and risk for New York Stock Exchange common stocks was tested using a two-parameter portfolio model and models of market equilibrium derived from the two parameter portfolio model.

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Abstract: This paper tests the relationship between average return and risk for New York Stock Exchange common stocks. The theoretical basis of the tests is the "two-parameter" portfolio model and models of market equilibrium derived from the two-parameter portfolio model. We cannot reject the hypothesis of these models that the pricing of common stocks reflects the attempts of risk-averse investors to hold portfolios that are "efficient" in terms of expected value and dispersion of return. Moreover, the observed "fair game" properties of the coefficients and residuals of the risk-return regressions are consistent with an "efficient capital market"--that is, a market where prices of securities

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14,171 citations