Working Paper: CEPR ID: DP2448
Authors: Maria Vassalou
Abstract: We test for the pricing of exchange rate and foreign inflation risk in equities. Our tests are motivated by the empirical implications of the models of Solnik (1974b) as revised by Sercu (1980), Grauer, Litzenberger, and Stehle (1976), and Adler and Dumas (1983). Both exchange rate and foreign inflation risk factors can explain part of the within-country cross-sectional variation in returns. Our results have important implications for hedging exchange rate risk. They also demonstrate that home bias, at least in US equity portfolios, cannot be the result of US investors' efforts to hedge their domestic inflation.
Keywords: International Asset Pricing; Foreign Inflation Risk Premiums; Exchange Rate Risk Premiums
JEL Codes: F30; F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exchange rate risk (F31) | variation in equity returns (G12) |
| foreign inflation risk (F31) | variation in equity returns (G12) |
| US inflation risk (E31) | equity returns in ten countries (G15) |
| exchange rate risk premiums vary across countries (F31) | capital markets not perfectly integrated (G15) |
| foreign inflation risk premiums vary across countries (F31) | capital markets not perfectly integrated (G15) |
| neglecting residual components of exchange rates (F31) | incorrect conclusions about pricing of exchange rate risk (F31) |
| home bias in US equity portfolios cannot be attributed to hedging domestic inflation risk (G15) | US inflation risk priced globally (E31) |