Global rice of Foreign Exchange Risk and he Local Facor Francesca Carrieri, Vihang Errunza and Basma Maerbi * Firs version: December 22 This version: Ocober 24 * Carrieri and Errunza are a he Faculy of Managemen, McGill Universiy, Monreal, Quebec, 3A1G5, Canada, Maerbi is a he Universiy of Vicoria, Vicoria, Briish Columbia, V8W 2Y2, Canada. Carrieri may be reached a francesca.carrieri@mcgill.ca; Errunza may be reached a vihang.errunza@mcgill.ca; Maerbi may be reached a maerbi@uvic.ca. We are graeful o Warren Bailey, Geer Bekaer, Jay Choi, Jean-Claude Cosse, Bernard Dumas, Wayne Ferson, Adiya Kaul and Luis Viceira for helpful commens and discussions. This paper has benefied from workshops a McGill Universiy and Laval Universiy. We also hank paricipans a he Inernaional Finance Conference in ammame, he Georgia Tech/Foris Ninh Annual Conference on Inernaional Finance, he 23 European Financial Managemen Associaion Meeings, he 23 Norhern Finance Associaion Meeings and a he 24 Emerging Markes Conference a he Darden School, Universiy of Virginia. Errunza acknowledges financial suppor from he Bank of Monreal Chair a McGill Universiy and SSRC. Carrieri acknowledges financial suppor from SSRC and IFM 2.
Absrac This paper provides new evidence on he pricing of exchange risk in global sock markes. We conduc empirical ess in a condiional seing wih a mulivariae GARC-in-Mean specificaion and ime-varying prices of risk for he US and nine emerging markes o deermine wheher exchange risk is priced under alernaive model specificaions and exchange rae measures. Since inflaion raes in emerging markes are high and volaile, we argue ha he use of real exchange raes offer a beer proxy for risk semming from purchasing power pariy deviaions. In addiion o using real exchange raes, he empirical model allows for parial inegraion by including a ime-varying price of local risk. Our main resuls suppor he hypohesis of significan exchange risk premia relaed o boh emerging and developed markes. The price of exchange risk is also significanly imevarying consisen wih previous evidence for maor developed markes. The empirical evidence also suggess ha here is variaion across counries and over ime in he relaive imporance of exchange risk premia. owever, currency risk remains an imporan global risk facor even afer accouning for local risk. Keywords: Inernaional Asse ricing, Currency risk, Emerging Markes, Inegraion, Segmenaion JEL classificaion: G12, G15 1
1. Inroducion Foreign exchange risk is one of he mos imporan dimensions of inernaional asse pricing. Indeed, under deviaions from purchasing power pariy (), exchange risk should be priced [see, for example, Solnik (1974), Sulz (1981), and Adler and Dumas (1983)]. 1 These inernaional asse pricing models (IAMs) include covariances of asse reurns wih changes in deviaions from in addiion o he covariance wih he world marke porfolio. Early aemps o es IAMs in an uncondiional seing were inconclusive. 2 More recenly, Dumas and Solnik (1995) and De Sanis and Gerard (1998) use a condiional framework and find evidence ha foreign exchange risk is priced in maor developed sock markes. Their resuls are based on models ha implicily assume full marke inegraion and sudy maor developed sock markes (US, UK, Japan and Germany). 3 Indeed, he available evidence is no sufficien o allow generalizaion abou wheher exchange risk is priced globally in differen marke environmens, such as emerging markes (EMs), ha are neiher fully inegraed nor compleely segmened. In addiion, many EMs have experienced some kind of currency crises wih overwhelming negaive impac on heir economies and sock markes. This may affec he percepion of foreign invesors wih respec o he imporance of exchange rae risk. I is hen ineresing o empirically see if such percepion is refleced in significan and/or larger foreign exchange risk premia in equiy reurns of emerging markes. Alhough heoreical models would sugges ha currency risk semming from hese markes migh no be as imporan since hey represen a small componen of he world marke capializaion, he issue of wheher foreign exchange risk is priced and is global economic relevance is o a large exen an open empirical quesion. 1 See Karolyi and Sulz (22) for an excellen discussion. 2 For example, amao (1988) and Jorion (1991) found no evidence ha exchange risk is priced on he Japanese and US sock markes respecively. owever, Vassalou (2), esing various uncondiional asse pricing models for en developed markes, found evidence ha exchange risk can explain par of he wihincounry cross-secional variaion in reurns. 3 Oher sudies wihin a condiional seing, [Choi, iraki and Takezawa (1998), Doukas, all and Lang (1999), Carrieri (21)] all end o srongly suppor he hypohesis ha foreign exchange risk is priced in sock markes of maor developed counries. 2
To dae, he lieraure ha focuses on exchange risk relaed o emerging sock markes is very sparse. Bailey and Chung (1995) sudy finds evidence ha Mexico s equiy marke premia are relaed o risk premia in he currency marke. Carrieri e al. (24) show ha informaion abou emerging marke episodes of crisis affec he prices of global risk facors such as he world marke risk and he maor currencies risk. hylakis and Ravazzolo (24) look a risk semming from local bilaeral exchange raes for a number of acific Basin markes. Our goal is o enhance our undersanding of he role of emerging sock markes in explaining global currency risks by accouning for boh developed and emerging markes currencies flucuaions and allowing for ime variaion in he prices of risk. For our invesigaion, we use a condiional framework under differen model specificaions and exchange risk measures. Based on daa from he US and nine emerging markes encompassing differen regions and differen exchange rae regimes, we aemp o provide some answers o he following relaed quesions: Is exchange risk a global facor ha commands a significan ime varying risk premium in differen cross secions of equiy reurns? If so, does he price of exchange risk remain significan once we accoun for local marke risk in a model ha assumes parial inegraion? Our base model uses he IAM of Adler and Dumas (1983). The base case assumes emerging markes are fully inegraed wih he world capial marke and allows us o compare our findings wih hose of Dumas and Solnik (1995) and De Sanis and Gerard (1998). This assumpion is hen relaxed and replaced by a parial inegraion hypohesis, which is more appropriae for he case of emerging markes. Our empirical mehodology is similar o ha of De Sanis and Gerard (1998) wih he excepion of he exchange rae specificaion. We use measures of real exchange raes o invesigae he significance of exchange risk pricing in emerging sock markes. We argue ha, in he case of EMs, his is more appropriae and also more consisen wih he original IAM of Adler and Dumas (1983) where boh world marke risk and deviaions are priced. revious empirical ess based on his model have assumed inflaion as negligible and simplified he model by idenifying changes in deviaions only wih nominal exchange rae changes. Alhough 3
his could be considered as a reasonable assumpion in he case of maor developed markes, we canno assume ha inflaion is nonrandom when we deal wih he relaively more inflaionary and volaile emerging economies. In he absence of such simplifying assumpion, we derive our empirical model where he covariances of asse reurns wih changes in deviaions are replaced by he covariances of asse reurns wih changes in real exchange raes. Since real exchange raes are inflaion adused, he change in he real exchange rae is a more correc measure of deviaions for our seing. I is well acceped ha emerging markes are neiher fully inegraed nor compleely segmened [see for example, Errunza, Losq and admanabhan (1992) and Bekaer and arvey (1995)]. The empirical evidence abou he behavior of emerging marke reurns provided by arvey (1995) suggess ha expeced reurns in hese markes are more likely o be influenced by local raher han global facors. ence, in our main esimaion, we follow Bekaer and arvey (1995) and De Sanis and Gerard (1998) and es for he significance of he pricing of exchange risk wihin he framework of a model ha allows for parial inegraion by including a ime-varying price of local marke risk. 4 Is inclusion is moivaed by he fac ha in parially inegraed markes, ess based on an IAM such as he fully inegraed framework of Adler and Dumas (1983) may resul in a spurious significance of he exchange risk facor because we are failing o accoun for oher relevan sources of risk such as he volailiy of he local marke facor. Our resuls can be summarized as follows. We find evidence ha currency risk is significan and ime-varying for a large number of asses from developed and emerging markes. Unlike he US marke where he world risk facor is he mos imporan, mos emerging markes show larger premia linked o he global exchange risk facors. On average over he whole sample, oal currency premia are negaive, confirming ha he hedging componen in currency premia is predominan. Toal currency premia are also economically significan as on average hey represen 14 percen of he oal premium in absolue erms across all global asses. Over subperiods, we find ha he conribuion from emerging markes currency risk can more han double for some EM asses. Local marke risk is ofen priced and a imes i subsumes he saisical imporance of currency risk. We 4
ake his as indicaion ha in emerging markes i is difficul o disenangle exchange rae risk from counry-specific risk. Alhough over he whole sample local marke risk is he larges componen, oal currency premia sill represen on average 21 percen of he oal premium across all EM asses. Therefore currency risk is an imporan economic risk facor in pricing global asses, even afer accouning for local risk. The res of he paper is organized as follows. Secion 2 oulines he model and mehodology. Secion 3 describes he daa and presens some preliminary analysis of emerging marke reurns. The empirical resuls from ess of exchange risk pricing under full inegraion and parial inegraion specificaions are presened in secion 4. Secion 5 concludes he paper. 2. Model and Mehodology 2.1. The model We begin wih he specificaion based on Adler and Dumas (1983) model ha assumes full inegraion. In a world wih L+1 counries, we can wrie he full inegraion model of Adler and Dumas (1983) as E L ( ri,, 1 1 i,, + w, 1 1 i, w, = 1 ) = δ cov ( r, π ) δ cov ( r, r ) (1) where r i and r w are excess reurns on he asse i and he world marke porfolio respecively, π is he rae of inflaion of counry expressed in he reference currency, E is he expecaions operaor, δ w is he price of world marke risk and δ s are he prices of inflaion risks. The erm cov (r i, π ) measures he exposure of asse i o purchasing power pariy deviaions ha sem from boh he inflaion risk and he exchange risk associaed wih counry. 4 revious empirical sudies ha include boh world and domesic marke facors along wih oher risk facors o es various forms of IAMs include Chan, Karolyi and Sulz (1992), Choi and Raan (1997), Choi, iraki and Takezawa (1998). 5
Dumas and Solnik (1995) and De Sanis and Gerard (1998) simplified he model by assuming ha domesic inflaion is non-sochasic. Since π π + e, 5 where π is he inflaion in local currency erms and e is he change in he nominal exchange rae beween he reference currency and he currency of counry, hey assume ha he only random componen in π is he relaive change in he exchange rae. Therefore, cov (r i, π ), is a pure measure of he exposure of asse i o he currency risk of counry and δ can be inerpreed as he price of risk of currency. This simplificaion is reasonable for maor developed counries where he changes in domesic inflaion relaive o exchange rae flucuaions are almos negligible. owever, for many emerging markes where inflaion is volaile, we canno subsiue he change in he nominal exchange rae for he inflaion rae π. In addiion, using only nominal exchange raes o proxy for purchasing power pariy deviaions is likely o cause misspecificaion of he esimaed risk premium as i would no accoun for he adusmen from local inflaion. One way o overcome he difficuly in empirical esing of IAMs for he case of high inflaion counries is o proxy he erm π by he change in he real exchange rae of currency insead of he nominal exchange rae (see proof in appendix 1) 6. As explained in he appendix, his would sill require an assumpion abou inflaion for he reference currency (he US dollar) o be non sochasic, which is reasonable. Inuiively, i is also more appealing o approximae he risk semming from deviaions wih he real exchange risk, since changes in he real exchange rae come from he combined effecs of changes in he inflaion differenial (beween counry and he US) and changes in he nominal currency value. In addiion, using changes in he real exchange rae helps 5 If is he price level in counry (expressed in he local currency ), hen he price level of counry expressed in U is: = S where S is he nominal exchange rae expressed as U/FC d d ds d ds Thus, = + + and, π π + e S S 6 Including boh inflaion risk and nominal exchange risk in he same model would lead o mulicollineariy problems given he generally high correlaion beween inflaion raes and exchange raes. As shown in Vassalou (2), while boh inflaion risk and exchange risk are significan pricing facors when considered separaely in various models, none of hese facors is significan when included oinly in he same asse pricing model. 6
overcome possible complicaions due o fixed exchange rae regimes or discree changes in nominal exchange raes due o devaluaions or peg removals. 7 Therefore, we esimae he following version of he Adler-Dumas model where only he reference counry inflaion rae (US) is assumed o be non-sochasic: L r i, ) = w, 1 cov 1( ri,, rw, ) +, 1 cov ( ri,, e, ) = 1 E( r δ δ (1a) where r e is he change in he real exchange rae of currency vis-à-vis he US dollar. δ can be inerpreed as he price of exchange risk afer adusing for inflaion changes. Theoreical models such as he one we propose above do no accoun for local sources of risk. 8 owever, here is mouning evidence ha emerging markes are neiher fully inegraed, nor compleely segmened [see Bekaer and arvey (1995), Carrieri, Errunza and ogan (23)]. A relevan empirical issue is hen wheher local risk is also priced for EMs, separaely from currency risk. Thus, we modify he model in (1) o depic a more realisic global marke environmen. We follow De Sanis and Gerard (1998) who include a consan price of local risk in a model wih global covariance risk. In our case, we es for he significance of he pricing of exchange risk wihin a framework ha allows for parial inegraion by adding a ime-varying price of local marke risk: E L ( ri. w, 1 1 i, w,, 1 1 i,, + i, 1 1 i, = 1 r ) = δ cov ( r, r ) + δ cov ( r, e ) δ var ( r ) (1b) where, δ i, he price of local marke risk for counry i, is incorporaed o measure counryspecific facors such as legal barriers o porfolio flows or differenial ax reamen across counries ha are no capured by he full inegraion model. This exension is imporan from an empirical perspecive since we wan o avoid a spurious significance of he currency risk due o missing facors. Our empirical specificaion wih ime-varying prices of world and local marke risks has he advanage of accommodaing he evoluion of he inegraion versus segmenaion 7 Using real exchange raes also allows us o apply he same model for counries wih differen exchange rae regimes. 8 A presen, here is no heoreical model ha accouns for boh deviaions and barriers o invesmens ha resul in marke segmenaion. 7
phenomena wihou having o fix he liberalizaion dae as in he dynamic inegraion models of De Sanis and Imrohoroglu (1997) and hylakis and Ravazzolo (24). 9 This is because some counries may have financial markes ha are inegraed wih he inernaional capial marke even in he presence of barriers, as shown in Bekaer and arvey (1995) for counries like Korea and Taiwan. 2. 2. Empirical Mehodology We firs esimae he full inegraion model in equaion (1a) oinly for a sysem of counries. The empirical model includes a ime-varying price of world marke risk and ime-varying prices of real exchange rae risk, r L w, 1 w, l, 1 n+, 1 = 1 = δ h + δ h + ε ε Ω ~ N(, ) (2) where: r is a vecor of excess reurns of S asses measured in a common currency; δ w, 1 is he price of world marke risk; δ are he prices of real exchange rae risks;, 1 Ω 1 is a se of informaion variables available o invesors a ime ; h i, is a column of he (S x S) covariance marix. We esimae he sysem in (2) for S asses, ha include 1<n<L counry equiy porfolios, up o L real currency porfolios and he world marke porfolio. The general IAM in (1) also provides a risk-adused equilibrium relaionship beween riskless ineres raes differenial and expeced changes in he nominal exchange raes. For his reason, Dumas and Solnik (1995) and De Sanis and Gerard (1998) use he IAM equaion o price he deviaions from uncovered ineres rae pariy and esimae he exchange premia in (1) hrough uncovered excess currency deposis. We focus on risk due o real exchange rae changes. By replacing nominal raes wih real raes and inflaion raes, we express he 9 These models ypically assume ha markes are fully segmened during he pre-liberalizaion dae (including only local risk) and fully inegraed hereafer (including only world marke risk) and do no model prices of risk as ime-varying. 8
currency porfolio pricing equaion in erms of changes in he real exchange rae. This implies ha real exchange rae risk can be explained by a sum of premia. The firs risk premium is he world marke risk premium while he oher premia are due o purchasing power pariy deviaions as in equaion (1). We hen modify our framework o accoun for parial segmenaion as in (1b). For each EM counry in he sudy, we esimae a sysem where he pricing equaion for he counry reurn includes a ime-varying price of domesic marke risk, δ i,-1, in addiion o a ime-varying price of world marke risk and ime-varying prices of real exchange rae risks: L i, w, 1 i, w,, 1 i, n+, i, 1 i, i, i 1 = 1 r = δ h + δ h + δ h + ε ε Ω ~ N(, ) (3) The expeced reurn of he oher asses in he sysem will depend only on world marke risk and real currency risk, in line wih he original model of equaion (1a). Differenly from Bekaer and arvey (1995), his empirical approach allows us o simulaneously esimae ime-varying global and local risk prices from he cross-secion of asses. We model he prices of world marke risk and exchange rae risk ( δ w, 1 and δ, 1 ) o depend only on a se of global informaion variables Z g,-1, while he price of local risk δ i,-1 is dependen on a se of local informaion variables, Z i,-1, which is counry-specific. 1 More precisely, we model he price of world marke risk as an exponenial funcion of he informaion variables o ensure ha his price is always posiive as implied by he heoreical model. The prices of currency risk can be modeled using a linear funcional form as here is no resricion on he price of currency risk o be posiive in he model. 11 The same linear specificaion is also used for he price of he local risk facor. δ w, 1 = exp (k w Z g,-1 ) (4) δ = k Z g,-1, = 1 o L (5), 1 δ = k i Z i,-1 (6) i, 1 1 We follow Dumas and Solnik (1995) and De Sanis and Gerard (1998) who use he same se of global insrumens for he price of world risk and he prices of currency risk. For he insrumens for he price of local risk, we rely on arvey (1991), and Bekaer and arvey (1995). 11 In Adler and Dumas (1983) heoreical model, he price of marke risk is always posiive as long as invesors are risk averse. owever, he price of currency risk can be negaive if he degree of risk aversion is greaer han one. 9
We use a linear specificaion for he price of local risk since we wan o accommodae negaive expeced reurns ha can be usified in periods of high volailiy or high inflaion when socks ac as inflaion hedge. This could be of paricular relevance for asses in emerging markes ha are characerized by high volailiy and, a imes, high inflaion. Since in his sudy we are ineresed in deermining he saisical and economic significance of currency risk premia relaive o world and domesic risk premia in pricing emerging marke asses, we follow he fully parameric approach used in De Sanis and Gerard (1997, 1998). We impose a diagonal srucure on he marices of coefficiens and assume ha he sysem is covariance-saionary so ha we can rewrie as a funcion of he uncondiional covariance marix of he residuals and a reduced number of parameers: 12 ' = *( ii' aa' bb') + aa'* 1 1 + bb'* 1 ε ε (7) where i is (Sx1) vecor of ones, a and b are (Sx1) vecors of unknown parameers and * denoes he adamard (elemen by elemen) marix produc. 13 The sysem is esimaed using he B (Bern, all, all and ausman (1974)) algorihm and quasi-maximum likelihood (QML) sandard errors are obained o ensure robusness of he resuls (see Whie (1982)). Even wih his parsimonious specificaion, a oin muli-counry esimaion of he model is compuaionally very difficul since i would include a large number of currency premia and local premia. In fac, according o he heoreical model, here should be as many currency premia as here are counries in he world. revious sudies wih similar mehodologies were limied o using few counries a a ime. 14 To reduce he dimensionaliy of a model, a common way used in he lieraure is o replace he differen 12 This means ha we assume ha he variances depend only on lagged squared errors and lagged condiional variance while covariances depend on he cross-produc of lagged errors and lagged condiional covariances. 13 This symmeric specificaion for he condiional variance-covariance marix has been successfully applied also o EMs daa in De Sanis and Imrohoroglu (1997). Moreover, modeling asymmery for EM reurns would be very complicaed as hey ypically show no specific paern in erms of posiive or negaive asymmery. owever, we check he relevance of asymmery in he residual diagnosics. 14 For example, four counries in he case of De Sanis and Gerard (1998), wih hree currency premia. 1
currency exchange raes by a single exchange rae measure such as a rade-weighed exchange rae index [see Jorion (1991), Ferson and arvey (1993, 1994), Choi, iraki and Takezawa (1998)]. To invesigae a large cross secion of counries, oher sudies, such as ardouvelis e al. (22) esimaed similar models in wo seps. 15 Clearly here are shorcomings o boh approaches. By using a single currency index, we lose informaion regarding he relaive pricing of some currencies wih respec o ohers, while a wo-sep esimaion procedure resuls in errors in variable problems and may affec he significance of he parameer esimaes. In our sudy, we find a compromise by invesigaing various versions of he model wihin sysems of differen number of asses. In our larges oin esimaion, we reduce he dimensionaliy of he model by using wo real exchange rae indices o separae he effecs of EM currencies flucuaions from hose of maor currencies. When we accoun for local marke risk alongside world and exchange rae risk, we reduce parameers proliferaion by considering a smaller number of asses. This seing also allows us o use real bilaeral exchange raes as an alernaive measure for he exchange risk facor o deermine he relaive imporance of he local currency risk versus local marke risk separaely for each counry. 4. Daa and Summary Saisics This sudy covers he US plus four counries in Lain America (Brazil, Colombia, Chile and Mexico) and five counries in Asia (India, Korea, Malaysia, hilippines and Thailand). We use monhly daa from January 1976 o December 2. Counry reurns are compued from naional oal reurn indices (inclusive of dividends) of he S&/IFC's Emerging Marke Daabase (EMDB). The dividend adused US marke and world marke reurns are obained from MSCI. All reurns are expressed in US dollar and compued in excess of he 3-day eurodollar deposi rae, used as a proxy for he risk-free rae, available from DaaSream. 15 ardouvelis, Malliaropulos and riesley (22) use a similar empirical framework bu wih a ime-varying degree of inegraion for he EMU counries. Their empirical mehodology involves a wo-sep esimaion where esimaes of he world and currency prices of risk obained in he firs sep are imposed in he second sage o ge esimaes of he individual counry prices of risk. This procedure has he advanage of reducing considerably he number of parameers o be esimaed bu leads o a loss of efficiency compared o he 11
Nominal bilaeral exchange raes wih respec o he dollar are from he Inernaional Moneary Fund's Inernaional Financial Saisics (IFS) and DaaSream. We compue real bilaeral exchange raes for each counry using nominal exchange raes and CI indices available from he IFS daabase. All bilaeral raes are expressed in US dollars by uni of he foreign currency so ha a posiive (negaive) change in he rae represens an appreciaion (depreciaion) of he foreign currency wih respec o he dollar. As menioned in secion 3, we use wo rade-weighed exchange rae indices compued by he Federal Reserve Board o separae he effecs of EMs currency flucuaions from hose of maor currencies. 16 These wo currency indices represen wo non-overlapping ses of all he imporan U.S. rading parners. The emerging markes group of currencies is included in he oher imporan rading parners (OIT) index. We will refer o his as he EM currency index. This group includes nineeen currencies ha are no heavily raded ouside heir respecive home markes. 17 The second group is summarized in he maor parners index, which we will refer o as he Maor currency index. 18 This group comprises sixeen maor currencies unil he inroducion of he euro and seven currencies afer ha even. 19 These wo currency indices are compued on a price-adused basis (real exchange rae indices) and provide a measure o approximae he sum of he various real exchange raes ha should be included in he model (see proof in appendix 2). 2 Table 1 repors summary saisics and correlaions beween excess marke reurns and he global risk facors (world reurn and real exchange rae indices). Compared o he world reurn characerisics, emerging marke reurns are large in some cases and show simulaneous esimaion procedure suggesed by De Sanis and Gerard (1997, 1998). I also fails o provide informaion abou he saisical relevance of global risks using he cross-secion of asses. 16 For more informaion on hese indices, see he Federal Reserve Bullein, Ocober 1998. 17 These counries are Argenina, Brazil, Chile, Colombia, Mexico, and Venezuela in Lain America; China, ong Kong, India, Indonesia, Korea, Malaysia, he hilippines, Singapore, Taiwan, and Thailand in Asia; Israel and Saudi Arabia in he Middle Eas and Russia in Easern Europe. 18 Many EMs are quie sensiive o he change in he value of he dollar wih respec o maor currencies such as he Japanese yen or European currencies due heir rade paerns or currency regimes. For insance, many Eas Asian economies, due o heir de faco peg o he dollar, are quie sensiive o he yen/u exchange rae flucuaion. Moreover, for many Eas Asian counries he volume of rade wih Wesern Europe is comparable o heir rade wih he US and Japan. 19 These are he currencies of he euro-area counries plus Ausralia, Canada, Japan, Sweden, Swizerland, and he Unied Kingdom. 2 We use he log-change in he inverse of each of he indices o capure he change in he real value of he foreign currencies wih respec o he dollar as i should appear in he model. 12
high volailiy. The daa also shows high levels of skewness and kurosis and he hypohesis of normally disribued reurns is clearly reeced by he Bera-Jarque es for all counries. Unlike he case of developed markes, emerging marke reurns are highly auocorrelaed as indicaed by he Q(z) 12 saisics in almos all counries excep Brazil, India and Korea. There is also a high level of auocorrelaion in he squared reurns series. The correlaions beween EMs reurns and he world marke reurn are generally low compared o wha is commonly observed for developed markes. Malaysia, hilippines, Mexico, Korea and Thailand show he highes correlaions o he world marke porfolio (beween.3 and.4). The correlaions of counry reurns wih he real EM currency index are generally higher han heir correlaions wih he real Maor currency index, excep for Brazil and Colombia. Malaysia, hilippines and Thailand have he highes correlaion wih he real EM currency index (beween.25 and.37). Table 2 repors summary saisics for he real bilaeral exchange raes compued for he nine emerging markes. In general, Lain American counries show larger variaions in he changes in real bilaeral exchange raes. The es for normaliy is also srongly reeced in he exchange rae series in all counries, while auocorrelaion levels are high only for Columbia, Korea and Mexico. In erms of correlaion of exchange rae changes wih he counries excess reurns, Korea, Malaysia and Mexico have he highes correlaion (around.5) followed by Thailand wih a.3 correlaion coefficien. Table 3 conains summary saisics for he insrumens used o describe he condiioning informaion se of he invesor. The choice of he global informaion variables is mainly drawn from previous empirical lieraure such as De Sanis and Gerard (1998) and Dumas and Solnik (1995) o faciliae comparison. The se of global insrumens includes a consan, he world dividend yield in excess of he risk-free rae (XWDY), he change in he US erm premium spread ( UST) and he US defaul premium spread (USD). The world dividend yield is he dividend yield on he world equiy index available from DaaSream. The erm premium spread is compued from he yield on he en-year US Treasury noes in excess of he yield on he hree-monh bills, boh available from he Federal Reserve Board (FRB). The defaul spread is measured by he difference beween Moody s Baa-raed and Aaa-raed corporae bonds also available 13
from he FRB. All variables are used wih one-monh lag relaive o he equiies excess reurns and he risk facors. As for he local informaion se, we rely on he work of arvey (1991) and Bekaer and arvey (1995). We use a predeermined selecion of counry-specific variables which includes: a consan, he local marke dividend yield in excess of he risk free rae (LCDY), he lagged local marke excess reurn (LagRe), and he change in local inflaion rae ( LCinf). Daa on local marke dividend yield are from he S&/IFC Emerging Marke Daabase. Local inflaion raes are compued from he log change in he counries CIs obained from he Inernaional Moneary Fund s Inernaional Financial Saisics. 5. Empirical Resuls 5.1. Exchange Risk ricing Under Full Inegraion We firs esimae model (2) where only he world marke and exchange rae facors are priced. This is he base case and can be inerpreed as a es of he condiional IAM of Adler and Dumas (1983) in equaion (1), under he assumpion of full inegraion and deviaions. Since we are ineresed in he quesion of wheher currency risks are ruly global, we always include he US asse in our esimaions. We esimae a sysem of six counry reurns (Brazil, Chile, Korea, Mexico, Thailand and he US), wo exchange rae indices (EM and Maor currencies) and he world marke reurn where he prices of risk are consan. 21 We find ha neiher world risk nor currency risks are priced. The findings of Dumas and Solnik (1995) and De Sanis and Gerard (1998) on he imporance of condiioning informaion are hus confirmed for a sample of emerging markes. Table 4 summarizes he resuls for he previous sysem of asses wih ime-varying prices of risk. Consisen wih previous evidence for developed markes, we find ha Maor currency risk is priced. There is also evidence ha he price of EM currency risk is saisically differen from zero and significanly ime-varying. The hypohesis of consan prices for he wo currency risk facors is reeced a he 1% level. On he oher hand, here 21 We use a subse of counries wih he longes available daa series. 14
is no srong evidence on he ime-variaion of he price of global marke risk. Diagnosics are provided in panel C. There is evidence ha GARC effecs have been removed by he specificaion and he non-normaliy in he daa is reduced alhough no eliminaed. This suppors our use of robus ess for inference. We also provide saisics for he presence of negaive and posiive asymmery. The resuls indicae ha for he vas maoriy of he counries he esimaed residuals show no asymmery. We repor he graphs of he esimaed prices of risk and he corresponding risk premia in Figure 1 and anel A of Figure 2, respecively. The average price for boh sources of currency risk is negaive and quie similar in size, -2.67 for he maor currencies and 2.94 for he EM currencies. Their size is also consisen wih previously repored prices of exchange rae risk esimaed from developed markes daa. Looking a he risk premia, we noe some imporan cross-counry variaions in he relaive sizes of world marke versus exchange risk premia. Unlike he US marke where he world marke premium is he mos imporan, mos emerging markes show larger premia linked o he exchange risk facor, paricularly wih respec o he risk of EM currency index. I is also eviden ha oal currency premia are negaive on average over he whole sample and his conforms o he belief ha he hedging componen in currency premia is predominan. 22 Ineresingly, over he Nineies, he EM currency premium is posiive for all asses. This migh be indicaion ha in his period characerized by persisen depreciaions, he hedging componen is no as imporan and invesors require posiive compensaion from aking on risk aached o EM currencies. Table 5 repors he esimaed premia as percenages of he absolue oal premium. From he able we infer ha oal currency premia are also economically significan as on average hey represen 14 percen of he oal premium in absolue erms across all asses. Looking only a emerging markes, we find ha for all of hem, excep Korea, he average conribuion of he currency componen is larger, reaching almos 2 percen in he case of Chile and Thailand. When we focus on he wo elemens of he oal currency premium, i is eviden ha for emerging markes he larges porion is represened by he EM currency premium componen, while he Maor currency premium componen represens he larges 22 owever, since oal currency premia are smaller han he marke premium, he oal premium is posiive on average. 15
par for he world marke porfolio. Currency risk is he smalles in he case of he US, which is he reference currency, a finding similar o De Sanis and Gerard (1998). Ineresing insighs can be obained when we invesigae premia over subsamples. We repor saisics for wo decades, he Jan. 1976 Dec. 1985 subsample ha includes he Lain American deb crisis, and he Jan. 1991 Dec. 2 subsample ha includes a large number of currency crisis, from he Tequila crisis in Mexico in 1994, o he Asian crisis in 1997, o he Russian defaul of 1998 and he Brazilian real devaluaion in 1999. I is eviden ha he size of he currency premium widens a imes and over subperiods i can represen up o 5 percen of he oal premium, such as in he case of Chile. In he fiveyear period beween he wo sub-samples characerized by he large depreciaion of he dollar in real erms, we find ha he Maor currency premium componen is significanly larger han is sample average, represening 17 percen of he oal. To furher enhance our undersanding on he relevance of global currency risks, we esimae a muli-counry model wih he four larges financial markes plus Mexico and Korea. 23 The evidence ha we obain is qualiaively similar. The specificaion ess show ha world risk is now marginally significan while currency risk is priced a any saisical level, confirming he global significance of EM currency risk also in a sysem ha accouns for fewer EM asses. For his se of counries, we also conduc a likelihood raio es beween an unresriced model wih wo currency premia and a model ha excludes he currency premium from he EM currencies. The resriced model is reeced in favor of he unresriced model wih a p-value of.7. Toal currency premia represen on average over he whole period almos 15 percen of oal absolue premium across all asses. Ineresingly, even for developed marke asses, he premium aached o EM currencies is of significan size when we compue i over subperiods. The EM currency componen is indeed as imporan as he Maor currency componen over he 76-85 period and he 91- period, while he Maor currency componen is larger during he dollar depreciaion period. 24 23 These are Germany, Japan, UK and he US, he same counries as in Dumas and Solnik (1995) and De Sanis and Gerard (1998). 24 We do no repor deailed resuls since hey are in line wih previously repored evidence, bu hey are available from he auhors upon reques. 16
Overall, hese resuls confirm hose of previous sudies for developed markes and, mos imporanly, offer iniial evidence ha financial asses worldwide provide compensaion no only for he risk of maor currencies bu also for currency risk of smaller financial markes. 5.2. Exchange Risk ricing Under arial Inegraion The saisical significance and he size of he currency premium could be due o he failure o include local marke risk premia. Tha is, he ime-varying risk premium for emerging markes could be aribued o he imporance of a local componen of sysemaic risk raher han a risk premium aached o currencies. To shed ligh on his issue we esimae a condiional IAM wih ime-varying prices of world and exchange risk and we include local risk. Alhough his specificaion is no based on an explici heoreical model, he facors are moivaed by widely used IAMs and pas empirical findings as explained in secion 3. Thus, in he absence of a formal model, we follow he esablished economeric radiion. We firs esimae a mulivariae sysem for Brazil, Chile, Korea, Mexico, Thailand and he US bu we add a consan price of local risk for each EM counry reurn. The evidence on he significance of currency risk is unchanged. Overall, currency risk is he mos relevan global source of risk since world risk is sill marginally significan. Boh currency groups are priced. When we look a he significance of local pricing, we canno reec he hypohesis ha he prices of domesic risk are oinly equal o zero. In paricular, we find ha he individual p-values for he prices of local risks are, respecively,.5983 for Brazil,.1782 for Chile,.8199 for Mexico,.2997 for Korea and.9614 for Thailand. This evidence on consan counry-specific risk is similar o he findings in De Sanis and Gerard (1998) on he four larges world financial markes and in De Sanis and Imrohoroglu (1997) on a sample of emerging markes. owever, we know ha ofen risk is priced only in a condiional framework. ence, we nex esimae he full model wih equaion (3) ha includes a ime-varying price of local marke risk for each EM counry. Since esimaion of a large muli-counry sysem wih ime-varying prices for all sources of risk is very difficul, we invesigae his issue wihin a smaller seing o reduce he 17
dimensionaliy of he problem. This will also allow us o es for he significance of EM currencies risk using real bilaeral exchange rae measures o capure he effecs of a counry s own currency risk on is equiies. 25 We conduc separae esimaions for each counry in our sample wihin a reduced sysem ha includes five asses: he EM counry, he US, he world and wo currency facors: he Maor currency risk and he local currency risk measured by he real bilaeral exchange rae of he counry s currency wih respec o he US dollar (he reference currency). 26 This es using bilaeral exchange raes is imporan for a leas wo reasons. Firs, since some previous sudies on currency risk pricing used bilaeral exchange raes [e.g. Dumas and Solnik (1995), De Sanis and Gerard (1998), and hilakis and Ravazzolo (24) for Asian EMs], i is ineresing o know wheher our previous resuls on he imporance EM currency risk are sensiive o he choice of exchange rae measures. Second, he significance of he local facor in he parial inegraion model could reflec he imporance of he local currency risk facor ha is undermined by using an aggregae exchange rae measure for EM currencies. I is herefore imporan o isolae he effec of he local currency facor from he broader counry-specific facor and deermine he relaive imporance of he risk premia associaed o hese facors. Table 6 repors he resuls of his parial inegraion model which includes besides he world and he Maor currency risk facors he local marke risk as well as he local currency risk for each emerging marke. 27 Unlike he resuls wih consan price of local risk, we find ha he ime-varying price of local marke risk is highly significan for Chile, Colombia, Korea, Mexico and hilippines, marginally significan for Thailand, bu no significan for Brazil, India and Malaysia. Among hese counries, i is ineresing o noe ha Chile and Korea showed no significan counry-specific risk in he consan price specificaion. The local currency risk is also significan for Chile, Colombia, Korea and hilippines and for hese counries i is no subsumed by he significance of he local 25 Esimaing exchange rae risk wih bilaeral exchange raes wihin a sysem wih a large number of asses would be unmanageable, as i would imply inclusion of a leas n-1 exchange rae premia for n asses. 26 For he las four asses we use he same pricing equaion as in (2). 18
marke risk. On he oher hand, he significance level of he Maor currency risk is affeced by he inroducion of he bilaeral rae and local risk facor as we find ha overall he price of currency risk is now significan for five counries. Finally, he price of world marke risk remains significan in all cases excep Mexico 28. Therefore, even wihin smaller sysems ha accoun for local risk, currency risk eners significanly as a global pricing facor. Table 8 repors esimaed risk premia as percenages of he absolue oal premium for he parial inegraion model esimaed above. We find ha alhough local risk represens on average he mos imporan componen of he oal risk premium for emerging markes, oal currency premia sill represen abou 21 percen of oal premium for emerging marke asses. One migh assume ha in he absence of a local facor, he currency facor migh proxy for local risk and hus is size would be significanly reduced in a model wih local risk. owever, his is clearly no he case, since EM currency risk remains an imporan componen even afer accouning for local risk. When we invesigae premia over subsamples, i is eviden ha he size of he EM currency premium widens a imes and over subperiods i can represen almos 4 percen of he oal premium, such as in he case of Colombia, Malaysia and Thailand in he Nineies, while in Mexico i accouns for over 5% of he oal premium during he subperiod ha covers he Lain American deb crisis. Toal currency premia can ofen be as large as he world risk premium. The magniude of he Maor currency premium is also larger over sub-samples, implying ha a imes EM asses provide sizable compensaion for currency risk also o developed markes invesors. As before, we find ha overall his componen of he currency premium is larger during he period of he real dollar depreciaion of he second half of he Eighies. 27 Given he imporance of he maor currencies as a global risk facor documened in previous sudies, we keep he Maor currency index in he sysem ha includes bilaeral exchange raes for EM currencies. 28 Alhough he evidence for Mexico is surprising, since i is expeced o be one of he mos inegraed emerging markes, previously repored evidence on his issue is also conflicing. For example, Bekaer and arvey (1995) show ha he esimaed degree of inegraion for Mexico is among he lowes, and Carrieri e al. (23) find ha condiional local risk is priced while global risk is no. 19
5.3. Robusness Checks Given previous evidence in he lieraure on he sensiiviy of he resuls wih respec o he exchange rae measure, we conduc wo robusness checks. Firs, we re-esimae he nine sysems in he previous es subsiuing for he real bilaeral exchange rae, he change in he EM currency index. Overall, we find ha he significance of he local marke facor seems o be largely unaffeced by he use of he EM currency index in place of he bilaeral exchange rae. I is sill significanly differen from zero and ime-varying for five counries. We also find ha he price of exchange risk remains significan for mos counries. When we look a he relaive saisical imporance of he wo currency groups, he Maor currency risk is always priced a he 1% significance level or beer, while he EM currency risk is priced for Brazil, Chile, India, Mexico and Thailand and no priced in he case of Colombia, Korea, Malaysia and hilippines. Compared o he resuls in Table 6, he only differences are for Mexico and Malaysia. For Mexico, exchange rae risk is now significan, while local risk becomes insignifican. In he case of Malaysia, we observe he opposie resul. Thus, for some counries, here is a link beween he local risk facor and he exchange risk facor and heir relaive imporance is affeced by he exchange rae measure. In anel B of Figure 2, we repor graphs of he risk premia esimaed from his specificaion wih he wo currency indices and local risk. Noe ha his seing is similar o he base case of full inegraion excep for he addiion of local marke risk for he EM counry. Therefore, i allows us o compare he robusness of he dynamics for he currency risks and o evaluae he conribuion of he local risk facor. Since we wan o focus on he relaive imporance over ime of he currency facors and he local facor, we omi he world risk premium. 29 We can clearly see ha he paern of boh currency risk premia is consisen o ha obained for he same counries in panel A. We also observe ha for mos counries, he size of he local marke risk premium is much higher han boh he world (no shown on graphs) and he currency risk premia. Alhough in some cases periods of large swings in he risk premia are mosly capured by he local risk facor, we can sill 2
idenify periods of crisis ha are characerized by an increase in EM currency premia such as Brazil, Chile and Mexico during he Lain American deb crisis of 1982-83 and Korea and Thailand during he Asian crisis of 1997-99. As a second check on he sensiiviy of he resuls wih respec o he exchange rae measure, we exclude he Maor currency index from he sysems of Table 6 and re-esimae he parial inegraion model using he bilaeral exchange raes as he only currency risk facor besides he world and local risk facors. We find ha he price of exchange risk remains highly significan for Mexico, Korea and Malaysia, significan bu ime invarian for India, marginally significan for Chile, while i is no significan for Brazil, Colombia and Thailand. Recall ha for he las hree counries, he exchange risk facor was significan in he previous models ha include exchange risk semming from maor currencies in addiion o EM currencies. 3 These resuls sugges ha, for some counries, he significance of currency risk can be sensiive o he choice of he exchange rae measure, and ha he relevance of such risk facor relaive o he local risk facor differs across counries. owever, we find evidence ha for he vas maoriy of counries, local marke risk and exchange rae risk are priced separaely, alhough in some cases i is hard o disenangle he wo risk facors. 31 In summary, he evidence repored in his secion suggess ha currency risk from emerging markes is a global facor since we find i o be saisically and economically significan, even afer accouning for local risk. 6. Conclusions The obecive of his paper was o invesigae he global pricing of exchange risk for emerging sock markes using a condiional inernaional asse pricing model ha allows for parial inegraion. To our knowledge, his is he firs es for EMs ha akes ino accoun boh exchange rae risk and local marke risk wih ime-varying prices in addiion 29 We only repor plos of hose counries included in he muli-counry sysem of able 4. Graphs for he oher counries of able 6 show similar dynamics wih large swings in boh currency and local risks over some crisis periods for EMs. They are available on reques. 3 In all our robusness checks, he price of world marke risk is always significan for all counries. 31 For example, Bailey and Chung (1995) find ha, in he conex of Mexico, i may be difficul o separae inflaion, currency and poliical facors. 21
o he ime-varying price of global marke risk. This model specificaion is he mos appropriae in he case of EMs because esing for exchange risk pricing using an ICAM assuming fully inegraed markes may resul in a spurious significance of he exchange rae risk due o he missing local risk facor. Since inflaion raes are high and volaile in EMs, real exchange raes provide a beer proxy for deviaions since hey capure boh inflaion and nominal exchange rae risk. Thus, in addiion o using an empirical model ha allows for parial inegraion, we also use real exchange raes. Our analysis esablishes he imporance of currency risk as a global pricing facor, even afer accouning for local risk. We find evidence ha emerging marke asses do provide compensaion for deviaions o global invesors. Our empirical resuls suppor he hypohesis of a significan price of exchange risk for emerging sock markes, in addiion o he exchange rae risk of developed markes. The price of exchange risk is also significanly ime-varying, which is consisen wih previous evidence for maor developed markes. While on average oal currency premia represen abou 14 percen of he oal premium in absolue erms, over subperiods he oal exchange risk premium increases for all global asses and more han double for some emerging marke asses. When we include local risk, currency risk sill represens a significan porion of oal premium. The resuls also sugges ha he use of an IAM wihou exchange risk (local risk) may be misspecified even when he model includes boh global and local (exchange) risk facors. This is because, he significance of he local risk facor may be overesimaed since i may subsume he missing exchange risk facor or vice versa. When we esimae a model ha accouns for boh risks, we find ha a imes he conribuion of currency risk o oal premia can be as large as ha of local risk. Thus, disenangling hese wo risks is clearly imporan for he invesmen and risk managemen decisions of porfolio invesors or companies ineresed in foreign direc invesmen, paricularly in emerging markes. 22