Is Currency Risk Priced in Global Equity Markets?

May 22, 2021

Is Currency Risk Priced in Global Equity Markets?
George Andrew Karolyi, Ying Wu
Review of Finance, Volume 25, Issue 3, May 2021, Pages 863–902, https://doi.org/10.1093/rof/rfaa026

Whether currency risk is priced or not has challenged international asset pricing scholars for four decades. Theory establishes that it could be so and outlines the many limiting forces that could play a role. The empirical evidence on how investors are compensated for bearing currency risk remains mixed. Our paper hypothesizes that some answers may have eluded us because the plethora of bilateral and multilateral exchange rates give no guide as to which reliably capture the systematic components of foreign exchange rate changes. To resolve this challenge, we exploit the findings of Lustig, Roussanov and Verdelhan (2011, 2014) and Verdelhan (2018) which identifies two new common risk factors that reliably capture the variation across exchange rates and over time – namely, a dollar-risk and a carry-trade risk factor. What we do is take these two novel exchange rate risk factors to the cross-section of global stock returns.

Our experiment examines monthly returns for over 47,000 stocks from 46 developed and emerging markets over a four-decade period. We benchmark these currency risk factors against a wide variety of global asset pricing models that allow for important sources of common covariation related to the market, as well as firm characteristics like size, value, momentum, profitability, and investment.

Our findings do uncover positive evidence on the pricing of currency risk in international equity markets, especially for that related to carry-trade risk. But we caution that it is critically important to include emerging markets for their validation in global asset pricing tests. There is also some critical instability over time and across regions.

We see our findings in this study as one important step forward offering useful insights for practitioners in guiding cost-of-capital calculations and in risk control or performance evaluation analysis of global portfolios.