Especially of both markets can help investors to

Especially
when we talk about emerging economies, it is observed that emerging economies
are much attractive for investment community. Emerging markets are considered more
volatile than developed markets, and according to risk and return theory
investors can reap more returns in developing countries than developed. Many investors
diversify their investment towards emerging economies in order to minimize
risk. If it is found that stock prices affect exchanges rates, the regularity authority
may take effective measures to stabilize the stock market. On the other hand,
relation of both markets can help investors to forecast about one market by
using information of the other.

Since
the inception of the floating exchange rate system in 1973, most developed countries
have allowed their currency exchange rates to float to some degree against other
major currencies. In a world with perfectly integrated capital markets, if
purchasing power parity (PPP) holds between two countries, then the real return
of an asset measured in either currency will be the same because exchange rate
changes will simply mirror differential inflation rates. On the other hand, if
PPP does not hold, the real returns for an asset denominated in different
currencies will in general be different. In this case, the uncertainty
associated with future exchange rate changes can affect expected returns on
securities (Adler and Dumas, 1984), and the fluctuation of exchange rates will
be a source of systematic risk on stocks and bonds. This risk is typically
referred to as foreign exchange risk or currency risk. By and large, the empirical
evidence indicates that PPP is often violated, at least in the short-run, and
this can therefore result in a foreign exchange risk for international equity
returns.

The
primary objective of this paper is to study the significance as well as the determinants
of foreign exchange risk exposures for equity index returns of eight Asian countries
for the period 1999-2016. We find that several macroeconomic variables can help
explain foreign exchange rate exposures. These variables include imports, exports,
credit ratings, Inflation, and tax revenues. We then suggest several possible
interpretations for the observed relations between exchange rate risk exposures
and these macroeconomic variables. The model that we use is grounded on the
international asset pricing model of Stulz (1981) and Adler and Dumas (1984).
Our definition of foreign exchange risk is based on the illustration in Adler
and Dumas (1984). The international asset pricing model specifies that an
asset’s expected return is associated with the covariance of the asset’s return
with the returns on the world market portfolio and with the covariance of the
asset’s return with the returns on foreign exchange rates. Alternatively, the
model specification and the importance of a foreign exchange risk factor may be
viewed within the context of arbitrage pricing theory (Ross, 1976), where asset
returns are characterized by a small number of common factors. The factors in
our model are the excess return on the world market portfolio and the excess
return on a country’s trade-weighted currency index. A number of other
researchers have examined the importance of foreign exchange risk in equity
returns. Prior studies using US market data have had only limited success in
documenting the significance of foreign exchange risk in equity returns (see, e.g.,
Jorion, 1990, 1991; Bartov and Bodnar, 1994). In contrast, research using
international equity returns typically finds significant currency betas.
Several studies find significant foreign exchange exposure using unconditional
factor models and international data. For example, Roll (1992) reports that
exchange rate changes explain up to 23% of the variation in equity index
returns for developed countries. He and Ng (1998) find that some Japanese
multinationals have significant positive exposure to foreign exchange rates.
Ferson and Harvey (1994) demonstrate the importance of a foreign exchange risk
premium in explaining international equity index return for 18 developed
markets. 5 Other studies find significant exchange rate risk using conditional
models. Among these, Ferson and Harvey (1993) find that the world market portfolio
and a trade-weighted currency index are the two most important factors in
explaining international equity returns. Dumas and Solnik (1995) and De Santis
and Gerard (1998) also find that the currency risk premium is significant for
international equity index returns. Choi et al. (1998) and Doukas et al. (1999)
show that conditional currency risk is important in explaining the stock returns
of Japanese firms. Ferson and Harvey (1997) examine the relationship between
risk, mispricing, and a number of macroeconomic and financial variables and
find that these variables primarily explain changes in risk exposures. In
summary, previous research using international equity returns generally finds
support for the significance of a foreign exchange risk premium.

Our
paper differs from the existing literature in several aspects. The betas are
allowed to change from year to year, but a priori, they are not assumed to be a
function of pre-specified variables. We use daily data on currency indices and
exchange rates to obtain relatively precise estimates of our annual betas. In
the second step, the estimated betas are regressed on annual country-specific
macroeconomic variables. This not only provides an econometric relation between
the exchange risk betas and macroeconomic variables, but more importantly
allows for a possible economic interpretation of the impacts of these variables
on currency risks.

The
findings in this paper may have some practical implications. For example,
portfolio managers interested in global asset allocation may want to understand
how currency risks differ across countries and what explains these differences,
and therefore this kind of information may be useful in their portfolio
selection decisions.

In
order to design hedging strategies for risk exposures to different currencies,
multinational corporations may be interested in predicting future exchange rate
risks by employing information about the current state of the macro economy.
Finally, the relation between currency risks and the macro economy may provide
useful information for government policy makers.