Foreign exchange risk and risk exposure in the Japanese stock market

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.