Measurement of exchange rate exposure and pricing of exchange rate risk
Abstract
The objective of the current research is to examine whether exposure to the systematic state variable(s), exchange rate(s), explains expected returns. By using average exchange rates to measure exposure, there may be a high level of measurement error due to the relatively low level of correlation of exchange rate movements. Therefore, in this study, exchange rates for specific currencies (Japanese Yen, Deutsche Mark, Canadian Dollar and British Pound) are used in the analysis. The empirical analysis follows the method of Fama and Macbeth (1973). The analysis investigates the pricing of an exchange rate state variable in a two factor capital asset pricing model on a sample of 582 firms. The results provide weak support for the weighted exchange rate change being an economic state variable which systematically influences asset prices. On the other hand when individual currencies are used as state variables exchange rate change seems more strongly to influence asset prices. In the completed analysis, portfolios were grouped on the basis of industry membership. Other groupings were (a) according to the 2-digit SIC code (b) firm size, and (c) the degree of multinationality. In addition to the two factor model, multi-factor models are also analyzed. In all analyses, the primary hypothesis of concern is that the parameter estimate of the risk premium of the exchange rate factor is significant. In contrast to Jorion's (1991) analysis, when individual currencies i.e. the Japanese Yen, Deutsche Mark, British Pound and Canadian Dollar are used there seems to exist a exchange risk premium for some sample periods and some portfolio formation. The results are very strong and indicate an existence of a risk premium when portfolio formation is by firm size. On the other hand, the results are not very convincing for all portfolio formation and all the different currencies. But the above set of results certainly indicate that there are some methodological flaws in Jorion's (1991) analysis, and therefore requires more research. (Abstract shortened by UMI.)
Degree
Ph.D.
Advisors
Kracaw, Purdue University.
Subject Area
Economics|Finance
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