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Shaun K. Roache is an economist in the Caribbean I Division of the Western Hemisphere Department. Matthew D. Merritt is Chief Global Investment Strategist for Insight Investment. We are grateful to David O. Robinson, Martin Muhleisen, Alejandro Justiniano, Jurgen Odenius, and Albert Leung for useful suggestions and comments. All remaining errors are ours.
It may be assumed that volatility would increase as a result of a currency realignment. However, the risks are currently well known by markets, yet implied volatility as measured by foreign exchange options is currently very low from a historical perspective.
These are effectively market-value-weighted industry portfolios.
One reason is the asset-liability structure of institutional investors. Long-term liabilities are often denoted in domestic currency rather than an international consumption basket and there is hence a strong incentive to retain a large domestic asset allocation weighting. The extent of home bias is revealed by Lane and Milesi-Ferreti (2001). Using stock market valuation adjusted foreign equity holdings at the end of 1998, the overseas weighting in the total equity portfolio of the total U.S. was below 12 percent. For the rest of the G-7, approximate weightings using the same data and Datastream total market capitalizations was 27 percent for the United Kingdom, 28 percent for Germany, 14 percent for France and Italy, 12 percent for Japan, and 29 percent for Canada.
There is also the key insight of Seigel’s paradox (Seigel, 1972). This implies that in a world where consumption opportunity sets differ across countries, there must exist some reward for currency risk. If the forward exchange rate for a country’s currency in terms of a foreign numeraire currency implies a zero expected excess return on foreign currency assets, then foreign investors expect to make positive excess returns on domestic assets. This is simply a result of Jensen’s inequality and the fact that for a random variable exchange rate e, E(1/e) ≠ 1/E(e) (see Karolyi and Stulz, 2002, for a fuller discussion).
For example, the correlation between exchange rates and equity markets has often changed significantly; indeed, in some cases there have been major sign switches.
These results omit the Italian Food Producer and Processing industry. Stock-specific issues in 2004, specifically related to Parmalat, resulted in very large outliers.
In most cases, a lag order of four obtained the highest information criteria.
Note that we refer to the factor-specific risk. Currency depreciation may also, more broadly, reflect lower economic and consumption growth. In this case, assets that covary relatively more positively with consumption (and potentially the currency) will attract a higher equilibrium return (see Parker and Julliard, 2003). However, in this study, such effects will be picked up by factors higher in the ordering, including the broad market and the long-term bond yield.
This assumes that the earnings of firms listed on the domestic equity market are indexed to local prices and inflation. With the liabilities of domestic institutional investors likely increasing in domestic prices (e.g., insurance funds), domestic equities provide a partial hedge against currency-related pass-through inflation. However, if the institutional investor’s liability is a fixed local currency amount or indexed against nontradeable prices, the investor’s incentive to hedge currency risk is either zero or lower than the ultimate beneficiary.