Foreign exchange risk and risk exposure in the Japanese stock market

Abstract

Purpose

Whether stock returns are linked to exchange rate changes and whether foreign exchange risk is priced in a domestic context are less conclusive and thus still subject to a great debate. The purpose of this paper is to provide new empirical evidence on these two inter‐related issues, which are critical to investors and corporate risk management.

Design/methodology/approach

This paper applies two different econometric approaches: Nonlinear Seemingly Unrelated Regression (NLSUR) via Hansen's Generalized Method of Moment (GMM) and multivariate GARCH in mean (MGARCH‐M) to examine the exchange rate exposure and its pricing.

Findings

Using industry data for Japan, similar to previous studies, foreign exchange risk is not priced based on the test of an unconditional two‐factor asset pricing model. However, strong evidence of time‐varying foreign exchange risk premium and significant exchange rate betas are obtained based on the tests of conditional asset pricing models using MGARCH‐M approach where both conditional first and second moments of industry returns and risk factors are estimated simultaneously.

Research limitations/implications

The strong empirical evidence found in this study implies that corporate currency hedging not only results in more stable cash flows for a firm, but also reduces its cost of capital, and hence is justifiable.

Originality/value

This paper conducts an in‐depth investigation regarding the exchange rate exposure and its pricing by utilizing two different econometric approaches: NLSUR via Hansen's GMM and MGARCH‐M. In doing so, a more reliable conclusion about the exchange rate exposure and its pricing can be drawn.

Citation

Tai, C. (2010), "Foreign exchange risk and risk exposure in the Japanese stock market", Managerial Finance, Vol. 36 No. 6, pp. 511-524. https://doi.org/10.1108/03074351011042991