The Pricing of Exchange Risk in Emerging Stock Markets

Author(s): Francesca Carrieri and Basma Majerbi

Source: Journal of International Business Studies, Vol. 37, No. 3 (May, 2006), pp. 372-391
Published by: Palgrave Macmillan Journals
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 of International
Journal Business
Studies
(2006)37,372-391
t 2006 Academyof International
Business Allrightsreserved0047-2506 $30.00
www.jibs.net

The pricing of exchange risk in emerging stock

markets

FrancescaCarrieri1
and Abstract
BasmaMajerbi2 In this paper, we provide new evidence about the unconditionalpricing of
exchange risk in the stock market, based on emerging market data. We
'Facultyof Management,McGillUniversity, conduct empiricaltests using cross-sectionaldata at the market,portfolioand
Montreal,Canada;2Facultyof Business, firm level from nine emerging markets(EMs)to determinewhether exchange
of Victoria,Canada
University risk is priced under alternative model specifications and exchange rate
measures. Our results support the hypothesis of a significantunconditional
Correspondence: exchange risk premium in emerging stock markets, differentlyfrom most
B Majerbi,Facultyof Business, Universityof unconditionaltests for majordeveloped markets.However,there is indication
Victoria, PO Box 1700 STN CSC,Victoria, that at the aggregate marketlevelthe significanceof the exchange riskfactoris
BC, Canada V8W 2Y2.
Tel: +1 250 472 4281; subsumed by local marketrisk.Withfirm-leveldata, although the importance
Fax: +1 250 721 6067; of local marketis confirmedfor most countries,some measureof exchange rate
E-mail:majerbi@business.uvic.ca riskremainssignificantfor most countries.This suggests that a carefulmodel
specificationis necessaryfor EMswhen testing for the pricingof exchange risk
in order to avoid a potential spurioussignificanceof such factor because of a
missing local riskor vice versa.
Journalof InternationalBusinessStudies(2006) 37, 372-391.
doi:10.I057/palgrave.jibs.8400204

Keywords: exchange risk pricing; unconditional asset pricing models; emerging

markets

Introduction
Foreign exchange risk is recognized, besides market segmentation,
as one of the most important dimensions of foreign investments
and international asset pricing. Indeed, the existence of currency
risk is among the major issues facing international investors,
because exchange rate volatility may reduce the benefits of
international diversification.
Capital flows into emerging markets (EMs) have increased
sharply in recent years, indicating a renewed interest by interna-
tional investors in the assets of these countries. In light of these
facts, the empirical question of whether foreign exchange risk is
priced in the stock market seems very relevant in the context of
EMs. These are countries known to offer valuable diversification
potential to international investors,' but at the same time they
tend to be characterized by large exchange rate uncertainty,
including the risk of devaluation for countries with fixed or pegged
exchange rate regimes. For instance, in 1994, following the sharp
Received: 6 April2004 devaluation of the Mexican peso and the various crises that swept
Revised: 24 June 2005 the country, American investors converting their Mexican portfo-
Accepted: 11 July2005 lios into dollars would have lost 42%, although the Mexican Bolsa
 Pricing of exchange risk in emerging stock markets
fell only 8.6% in peso terms. More interestingly, the
impact of exchange rate movements goes beyond
the 'pure translation' risk to affect stock prices
through their fundamental impacts on firms'
expected cash flows. The fall of the Brazilian real
in January 1999 and its negative impact on the
Brazilian stock market is a good illustration of the
sensitivity of equity values to exchange rate changes.
Theoretically, the relation between exchange
rates and stock prices has been clearly identified
by early models such as Shapiro (1974), Dumas
(1978) and Choi (1986), based on the potential
impacts of exchange rate movements on the firm's
expected cash flows. In addition, stock markets and
exchange rates might be correlated when driven by
similar macroeconomic variables, especially in EMs
where currency and stock markets are closely linked
to the country's economic situation. It has also
been shown that a non-zero exchange risk pre-
mium in stock returns may exist because of
deviations from purchasing power parity (PPP).2
Under such conditions, investors may consider a
foreign investment as riskier, perceiving exchange
risk as a real currency risk that is partly non-
diversifiable, and hence require some compensa-
tion in terms of expected returns when investing in
foreign stock markets.
In this paper, we conduct various empirical tests
to investigate whether foreign exchange risk is
unconditionally priced in emerging stock markets.
Using data from nine countries encompassing
different regions and different exchange rate
regimes, we attempt to determine whether
exchange risk is priced in emerging stock markets,
in the sense that it commands a significant non-
zero risk premium in stock returns, under alter-
native model specifications and varying market
structures.As many EMshave experienced currency
crises with overwhelming negative impacts on their
economies and possibly on their stock markets, it is
then interesting to know how average currency
premia in emerging market equities compare with
what has been evidenced for developed stock
markets in previous studies.3 The answers to these
questions have important implications for model-
ing and testing international asset pricing theories
as well as for the determination of the cost of
capital of firms operating in the international
capital market.
The rest of the paper is organized as follows. In
the first section we briefly discuss the existing
empirical literature on the pricing of exchange risk
in the stock market, and motivate our approach.
F CarrieriandB Majerbi
373
The following section outlines the model and
methodology, and then we describe the data and
present some preliminary statistical analysis of
emerging market returns. After this, the empirical
results from tests of alternative asset pricing models
are presented. The final section concludes the paper.
Previous research
Theoretically, if the effects of currency risk do not
vanish in a well-diversified portfolio, exposure to
the exchange risk factor should yield a risk
premium. On the other hand, if PPP holds and if
there are no barriers to international investments
and no differences in consumption goods, then the
single-index capital asset pricing model (CAPM)
should hold internationally, and exchange risk
should not be priced. Given the wide empirical
evidence against such a perfect world, some early
theoretical studies considered the effects of foreign
exchange risk on asset returns and developed
international asset pricing models that include
exchange risk factors along with the traditional
market risk factor (Solnik, 1974; Sercu, 1980; Stulz,
1981a; Adler and Dumas, 1983 and the review by
Solnik (1997)). On the empirical side, the evidence
from testing unconditional asset pricing models is
quite mixed and fragmentary. Early tests, such as
Hamao (1988) and Jorion (1991), were rather
inconclusive and generally found no evidence that
exchange risk is priced on the Japanese and US
stock markets. Recently, Vassalou (2000) finds that
exchange risk, along with foreign inflation risk, can
explain part of the cross-sectional variation in
equity returns of 10 developed countries. Moreover,
latest studies based on conditional asset pricing
models tend to provide more consistent results,
strongly supporting the hypothesis that foreign
exchange risk is priced in the stock markets of
major developed countries (e.g., Dumas and Solnik,
1995; De Santis and Gerard,1998; Choi et al., 1998;
Doukas et al., 1999; Carrieri,2001).
Such evidence is not sufficient to reach more
general conclusions on exchange risk pricing in
global equity markets. This literature has, in fact,
some limitations that still need to be addressed.
First, most of the studies that find no evidence of an
exchange risk premium use aggregate market data.
This could explain ambiguous results, because the
exchange risk exposures of different firms may
offset each other when those firms are grouped into
an aggregate market index measure. To address this
issue, we use data at different levels of aggregation,
from a cross-section of national stock indices to a
Journal of International Business Studies
 Pricing of exchange risk in emerging
374
cross-section of local stocks. Second, previous
studies are limited to the context of major devel-
oped markets (DMs), and derive their conclusions
by testing models that implicitly assume full
market integration. This is not very informative in
different market environments such as EMsthat are
neither fully integrated nor completely segmented
from global financial markets (Errunzaet al., 1992;
Bekaert and Harvey, 1995).
In this paper, we conduct our analysis with an
unconditional approach because some characteris-
tics of EMs, such as the long-run depreciations of
their currencies generally observed with respect to
the dollar and the recurring periods of turbulence
that they have experienced over the span of the last
two decades, differentiate them from developed
markets. Indeed, it is likely that we are able to
detect currency risk only conditionally with devel-
oped markets country index data exactly because
there is no common information on average that
explains indices over the whole sample, whereas
this could not be the case for EMs. We test for the
existence and significance of exchange risk premia
within an unconditional model that accounts for
other competing sources of local risk that could be
related to changes in the broader economic or
political environment in a given country. Given the
likely differences in market structure from devel-
oped markets and the large impact that exchange
rate changes have on EMs,the question of whether
currency risk is priced on average over the long run
in these markets is an interesting one.
Empirical model and methodology
The starting point of our empirical procedure is a
standard multi-beta pricing model where we
assume that expected asset excess returns are linear
functions of factor risk premia and their corre-
sponding betas:
k are the risk premia associated with the world and
rit= + (E Fit)+1it
ij=
(i - 1,..., N ; t l= ,...,T)
- then at portfolio and firm-level data. The impor-
and k tance of an exchange rate factor can be justified
E(rit) L i.
j=l
where rit is the excess return on asset i at time t,
measured in US dollars (the reference currency);4lii
are the assets sensitivities to the global risk factors Fj
(U=1, ..., k); 2j are the expected
associated with the factors and; Eit are random
errors.5
journal of International Business Studies
stock markets F Carrieriand B Majerbi
The choice of factors in such models is not
formally dictated by a specific theoretical frame-
work. Therefore, we follow the empirical tradition
and predetermine the global risk factors to investi-
gate based on the implications of some established
international asset pricing models.
We follow Ferson and Harvey (1994) and estimate
the beta pricing model in Eq. (2) as a restricted
seemingly unrelated regression model (SURM):
k
rit = +ji) + Eit (i= 1,...,N) (3)
fit
1=1
where f, are the de-meaned values of the risk factors
(fjt=Fjt-mean(Fjt))and E(eit)=O.The regression is
restricted by assuming that the intercept is equal to
zero. This specification allows us to use economic
variables, such as the change in the exchange rate,
as factors.6 The parameters to be estimated using
Eq. (3) are the unconditional betas (fPi) and the
expected riskpremia (A2)for the model's risk factors.
We test two- and four-factor models, at the market,
portfolio and firm-level data, as described below.
Our objective is to determine the size and signifi-
cance of the i coefficient related to the pricing of
the exchange risk factor under alternative model
specifications.
The pricing of exchange risk in an international
CAPMframework
We first test an unconditional version of model (3)
where the risk factors are the world market excess
return (rw) and the change in an aggregate
exchange rate measure (s):7
rit = fiwrt +- isst + wJiw + +it (4)
w
isfis +-
where rwtis the world market excess return in US
dollars, st is the change in the real exchange rate
index; fliwand #is are the sensitivities of asset i to the
world and the exchange risk factors; and w,and is
exchange risk factors, respectively.
(1) Eq. (4) is our empirical two-factor model to be
tested first at the aggregate market-level data and
(2) from the international CAPM framework of Adler
and Dumas (1983), where PPP fails to hold. As in
previous studies, we use a single exchange rate
measure as a proxy for the exchange risk factor.8
However, unlike previous studies, we use the
risk premia change in the real exchange rate index that is more
consistent with the original model of Adler and
Dumas (1983).9 As inflation in most EMs can be
 Pricing of exchange risk in emerging stock markets
high and volatile, it would be inappropriate to
proxy PPP deviations with the change in the
nominal exchange rate. Including both an inflation
factor and a nominal exchange factor would likely
lead to multicollinearity problems, given the gen-
erally high correlation between inflation and
exchange rates over the long horizon, especially
for EMs.10 Instead, using the change in the real
exchange rate takes into account both a country's
inflation level and the change in its nominal
currency value. Moreover, using changes in the
real exchange rate helps overcome possible com-
plications due to fixed exchange rate regimes or
large discrete changes in nominal exchange rates
due to devaluations or peg removals.
The pricing of exchange risk under partial
segmentation
With world market risk and foreign exchange risk,
the model in Eq. (4) implicitly assumes that
markets are fully integrated. Some early studies
have developed international asset pricing models
under various forms of market segmentation (Stulz,
1981b; Errunzaand Losq, 1985). Indeed, a growing
literature suggests that capital markets are neither
completely segmented nor fully integrated because
of the existence of various barriersto international
investments and capital flows (Bekaertand Harvey,
1995). This issue becomes more relevant in the case
of EMswhere exposure to local risk factors has been
established.11
This evidence motivates testing for the pricing of
exchange risk in emerging stock markets within the
context of a partial segmentation model where
idiosyncratic risks are also priced. Therefore, we
estimate the following four-factor model where
local market risk and local exchange risk are priced
factors, in addition to common world and
exchange risk factors:
rit =-iwrwt + + Iisst + f#sS
ee
1imrmet (5)
+ + sis + # + .it
+"wiw mi fis
In this model, raetis the residual from a regression
of the local market excess return on the world
market return rwt,and it is used as a measure of
idiosyncratic market risk besides the common
world market factor. Similarly, the idiosyncratic
exchange risk s' is measured by the residual from a
regression of the local real exchange rate on the
common exchange rate index st. /f3mand fls are the
sensitivities to the idiosyncratic market and 'local'
FCarrieri
andB Majerbi
375
exchange risk factors respectively; and Z, and Z are
the corresponding risk premium parameters.
The decomposition of the factors into 'common'
and 'idiosyncratic' components is similar in spirit
to the risk decomposition used in Vassalou (2000).
In that study, the idiosyncratic exchange risk
component is an average of the residuals from the
regressions of each bilateral exchange rate on the
other countries' exchange rates, and the common
component exchange rate is an average of the fitted
values from the same regressions. In our study, we
directly use a trade-weighted exchange rate index,
as a measure of the common exchange rate
component.12 For joint multicountry estimations,
the idiosyncratic exchange risk measure is then
constructed by taking the average of the residuals
from regression of each country's bilateral
exchange rate on the common exchange rate index
and a constant. When using individual stock
returns in a single-country setting, we consider
only the residual of the projection of the country's
local exchange rate on the common exchange risk
index. However, we also test the robustness of our
results by using alternative exchange risk factor
specifications, as shown later in the paper, in the
section on 'Asset pricing tests results.'
Each system of equations in models (4) and (5) is
estimated using Hansen's (1982) generalized meth-
od of moments (GMM) and allowing for contem-
poraneous correlations in the error terms eit as in
SURM. The expected risk premium parameters )
and the beta coefficients in each model are jointly
estimated in a one-step procedure to avoid the
errors-in-variablesproblem implied by a two-step
estimation procedure a la Fama and MacBeth
(1973). We use a vector of ones and the contem-
poraneous values of the factors Fjt as the instru-
ments in the GMM estimation. Therefore, the
orthogonality conditions are E(CitFjt)=Oand E(sit)=0
for all i=1, ..., N and j=1, ..., k. The iterated GMM
procedure employs the Newey-West (1987) estima-
tor to correct for heteroskedasticity and autocorre-
lation in the variance-covariance matrix of the
parameters.13 The truncation parameter q in the
Newey-West estimator is set equal to 6, which
reasonably takes into account the number of
significant lags in our dataset. We report estimates
of the unconditional betas and the corresponding
factors risk premia as well as Hansen's (1982) J-test
on the over-identifying restrictions.14 The regres-
sion models in (4) and (5) are over-identified
because we impose the standard CAPM-type restric-
tion on the parameters by setting the intercepts
Journal of International Business Studies
 Pricing of exchange risk in emerging stock markets
376
equal to zero. Finally, we provide additional
diagnostic tests based on the estimated mean
pricing errors (average pricing errors (APE)), root
mean-squared errors (RMSE)and adjusted coeffi-
cients of determination (adj-R2).
Data description and preliminary analysis of
emerging market returns
The countries covered in this study are Argentina,
Brazil, Chile, Mexico, Greece, India, Korea, Thai-
land and Zimbabwe. These are the nine countries
from the S&P/IFC Emerging Market Database
(EMDB),for which we have the longest data series
of returns on a monthly basis.
Market-level returns are computed from national
total returns indices (adjusted for dividends) from
January 1976 to October 1999. For portfolio-level
tests, we construct four value-weighted size-based
quartile portfolios for each of the nine countries
(for a total of 36 portfolios) from all listed securities
over the same sample period. In addition, we
conduct some tests with industry portfolios using
24 industry indices available in the EMDB since
January 1985.15 These industry indices are com-
puted at the aggregate level across all EMs. The use
of industry-level returns is motivated by the need to
compare with previous studies based on industry
portfolio returns, such as Jorion (1991). In addition,
as each industry index includes securities from all
EMs, this offers the advantage of testing for the
pricing of exchange risk in the context of well-
diversified portfolios. Panel C of Table 1 provides a
detailed listing of the industry groups with the
summarystatisticsover the 1985-1999 sample period.
Individual stock returns are computed from price
and dividend series available from the same
database at the firm level from 1985 to 1999. Only
securities with data available for the whole sample
period are selected (for a total of 105 firms). This
has survivorship bias but, given the large number of
parameters to be estimated and our methodology,
such restriction is necessary to enhance the power
of statistical tests with longer data series while
preserving an informative cross-section over the
whole sample period.16 In addition, as we also use
market and portfolio-level data, our overall conclu-
sions are less affected by the survivorship bias for
the firm-level tests."17Panel D of Table 1 contains
data on the firms, with the number of firms
included in the sample, their market capitalization
as proportion of the total market capitalization,
average mean and average s.d. across firms. The
Appendix A provides more detailed information on
journal of International Business Studies
FCarrieri
andB Majerbi
the industry breakdown for the firms included in
the sample.
The world market return is computed from MSCI
World Index adjusted for dividends and available
from DataStream. The composite EM return is
obtained from the S&P/IFCcomposite stock index.
All returns used in the empirical tests are expressed
in US dollars and computed in excess of the 30-day
eurodollar interest rate (used as a proxy for the risk-
free rate) available from DataStream.
As a measure of the common exchange risk
factor, we use the real 'other important trading
partners' (OITP) index computed by the Federal
Reserve Board. This is a trade-weighed exchange
rate index of the US dollar, the reference currency,
with respect to 19 currencies that include most
EMs'currencies.18We shall referto this index as the
EM currencyindex. We also use a broader exchange
rate measure that includes developed market
currencies as an alternative common exchange risk
factor. This is the 'broad' index, which, in addition
to the EMscurrencies, includes 16 major currencies
until the introduction of the euro and seven
currencies after that event.19 We shall refer to this
index as the broad currency index. These two
currency indices are computed on a price-adjusted
basis (real exchange rate indices) and provide a
measure to approximate the sum of the various real
exchange rates that should be included in the
model.20 We use the log-change in the inverse of
each of the indices to capture the change in the real
value of the foreign currencies with respect to the
dollar as it should appear in the model.
Our measures of the idiosyncratic exchange rate
components are obtained from the residuals of the
regression of real local exchange rates on the
common exchange rate index. We compute real
bilateral exchange rates for each country using
nominal exchange rates and CPI indices available
from the International Monetary Fund's Interna-
tional Financial Statistics (IFS)and DataStream. All
bilateral rates are expressed in US dollars by unit of
the foreign currency so that a positive (negative)
change in the rate represents an appreciation
(depreciation) of the foreign currency with respect
to the dollar. As with exchange rate indices, we use
the log change in the real bilateral exchange rates.
Table 1 reports summary statistics and autocorre-
lations for excess market and portfolio returns.
Panel A shows that, compared with the world
return characteristics, emerging market returns are
high on average for some countries and are
generally more volatile, especially in the Latin
 Pricing of exchange risk in emerging stock markets andB Majerbi
FCarrieri
377

Table 1 Summarystatisticsfor excess returns

Mean S.d. Skewness Kurtosis Autocorrelations

P P2 P3 P4 P5 P6
Panel A: Countryreturns
Argentina 0.0379 0.259 2.28** 10.65** 0.055 0.064 0.114 -0.040 -0.042 0.063
Brazil 0.0129 0.162 0.48** 1.44** 0.041 -0.057 -0.061 -0.053 -0.031 0.007
Chile 0.0177 0.106 0.89** 3.63** 0.172a 0.209a -0.008 0.003 0.016 -0.009
Mexico 0.0135 0.124 -0.84** 3.48** 0.233a -0.042 -0.025 0.007 0.093 -0.046
Greece 0.0057 0.101 1.54** 6.26** 0.1 32a 0.149a 0.010 -0.061 -0.010 0.099
India 0.0072 0.081 0.58** 1.42** 0.074 0.034 -0.052 -0.071 -0.002 0.087
Korea 0.0088 0.111 1.33** 6.28** 0.036 0.025 -0.006 -0.031 0.042 0.078
Thailand 0.0062 0.101 0.35* 3.56** 0.150a 0.133a -0.086 -0.137a-0.074 0.038
Zimbabwe 0.0034 0.105 -0.17 2.24** 0.194a 0.151a 0.245a 0.154a 0.108 0.085
World index 0.0058 0.004 -0.56** 1.94** 0.020 -0.062 -0.041 -0.042 0.137a-0.060
EMcomposite index 0.0007 0.069 -0.28 1.80** 0.163a 0.135a -0.003 0.075 -0.021 -0.010

Panel B: Size-based portfolio returns

Argentina
Portfolio 1 0.0511 0.356 4.06** 29.28** 0.114 0.168a 0.049 -0.017 -0.076 -0.009
Portfolio2 0.0491 0.323 3.26** 19.29** 0.093 0.129a 0.065 -0.019 -0.037 -0.016
Portfolio 3 0.0490 0.296 2.25** 8.53** 0.092 0.100 0.070 -0.037 -0.024 0.056
Portfolio4 0.0664 0.277 2.31** 9.81** 0.075 0.070 0.159 -0.007 -0.038 0.090

Brazil
Portfoliono. 1 0.0109 0.208 1.71** 8.13** 0.049 -0.125a -0.056 -0.020 -0.078 -0.009
Portfoliono. 2 0.0235 0.189 1.68** 7.27** 0.033 -0.031 -0.131a-0.014 -0.023 0.087
Portfoliono. 3 0.0267 0.190 1.31** 4.58** -0.023 -0.074 -0.103 -0.018 -0.051 0.024
Portfoliono. 4 0.0411 0.015 1.05** 1.95** 0.100 -0.032 -0.067 -0.060 -0.060 0.006

Chile
Portfoliono. 1 0.0087 0.128 0.86** 2.13** 0.098 0.176a 0.078 -0.028 0.084 0.077
Portfoliono. 2 0.0204 0.126 1.17** 3.18** 0.205a 0.196a -0.066 0.025 -0.100 0.049
Portfoliono. 3 0.0273 0.112 0.81** 2.12** 0.153a 0.125a -0.042 -0.034 -0.024 0.005
Portfolio no. 4 0.0304 0.116 1.80** 10.75** 0.124a 0.226a -0.015 -0.018 0.009 -0.044

Mexico
Portfoliono. 1 0.0046 0.146 0.18 4.72** 0.235a -0.044 -0.032 0.083 -0.028 -0.023
Portfoliono. 2 0.0226 0.143 0.49** 4.62** 0.242a 0.043 0.081 0.061 0.054 -0.049
Portfoliono. 3 0.0204 0.131 -0.47** 2.96** 0.287a 0.022 -0.042 -0.059 0.054 -0.050
Portfoliono. 4 0.0292 0.137 -0.29* 2.58** 0.176a -0.066 -0.030 0.029 0.124a-0.035

Greece
Portfoliono. 1 -0.0010 0.102 1.15** 4.23** 0.222a 0.087 0.030 -0.017 0.025 0.267a
Portfoliono. 2 0.0137 0.107 1.86** 6.73** 0.261a 0.223a 0.059 0.006 -0.016 0.130a
Portfoliono. 3 0.0199 0.122 2.85** 13.82** 0.219a 0.182a 0.147a 0.002 0.129 0.134a
Portfolio no. 4 0.0072 0.116 1.40** 8.39** 0.122a 0.140a -0.088 -0.038 -0.054 0.060

India
Portfoliono. 1 -0.0014 0.102 1.04** 6.86** 0.081 -0.048 -0.051 -0.140a 0.111 0.140a
Portfoliono. 2 0.0084 0.088 0.69** 3.25** 0.111 0.002 -0.072 -0.080 0.073 0.072
Portfoliono. 3 0.0144 0.082 0.75** 2.18** 0.017 0.080 -0.078 -0.099 0.062 0.056
Portfoliono. 4 0.0161 0.088 0.91** 2.08** 0.100 0.018 -0.035 -0.043 -0.032 0.068

Korea
Portfoliono. 1 0.0056 0.140 1.42** 7.89** 0.162a 0.008 -0.055 0.087 -0.018 -0.006
Portfoliono. 2 0.0089 0.123 1.12** 5.06** 0.084 -0.005 -0.033 0.156 0.109 0.056

Journal of International Business Studies

 Pricing of exchange risk in emerging stock markets FCarrieri
andB Majerbi
378

Table 1 Continued
Mean S.d. Skewness Kurtosis Autocorrelations

P P2 P3 P4 P5 P6

Portfolio no. 3 0.0142 0.122 1.46** 7.37** 0.042 0.003 -0.008 0.039 0.072 0.107
Portfolio no. 4 0.0222 0.122 1.74** 7.51** 0.049 0.022 0.000 -0.074 0.049 0.076

Thailand
Portfolio no. 1 -0.0067 0.175 4.43** 38.91"* 0.085 0.040 -0.020 -0.008 0.019 -0.015
Portfoliono. 2 0.0047 0.145 1.89** 11.07** 0.216a -0.016 -0.104 -0.177a-0.110 0.040
Portfoliono. 3 0.0152 0.137 1.88** 9.38** 0.150a 0.013 -0.144a-0.171a-0.126a 0.013
Portfoliono. 4 0.0168 0.097 0.70** 3.35** 0.120a 0.163a -0.082 -0.106 -0.077 0.050

Zimbabwe
Portfoliono. 1 -0.0081 0.149 0.72** 4.04** 0.008 0.144a 0.118 0.067 0.051 -0.019
Portfolio no. 2 0.0097 0.137 0.26 1.78** 0.073 0.238a 0.087 0.238a-0.008 0.064
Portfolio no. 3 0.0037 0.129 0.06 1.22** 0.222a 0.206a 0.252a 0.211a 0.154a 0.126a
Portfolio no. 4 0.0245 0.119 0.41** 2.41"* 0.133a 0.089 0.186 0.094 0.035 0.032

Panel C: Industryportfolio returns

Mining 0.0063 0.108 0.37* 2.23** 0.249a -0.047 -0.065 -0.070 -0.043 -0.087
Food and kindred 0.0102 0.063 -0.64** 2.64** 0.186a 0.096 0.031 -0.092 0.028 -0.061
products
Tobacco manufactures 0.0157 0.097 0.21 0.73 -0.035 0.070 -0.052 -0.175a 0.069 0.009
Textile mill products 0.0085 0.103 0.52** 2.55** 0.081 0.048 -0.046 0.054 0.102 -0.019
Apparel and other 0.0042 0.099 0.66** 2.43** 0.027 0.041 0.061 -0.100 -0.090 -0.048
textile products
Lumberand wood 0.0128 0.196 1.30** 3.52** -0.027 -0.051 -0.105 -0.083 -0.018 -0.055
products
Furnitureand fixtures 0.0050 0.148 0.21 2.00** 0.210a 0.215a 0.076 0.032 -0.068 0.002
Paper and allied 0.0121 0.094 0.96** 8.22** 0.191a -0.023 -0.077 0.049 0.168a-0.019
products
Chemicals and allied 0.0078 0.068 0.24 1.72** 0.209a 0.164a -0.001 -0.115 -0.007 0.004
products
Petroleum refining and 0.0081 0.109 0.59** 3.06** 0.151a 0.114 -0.005 -0.086 -0.043 -0.003
related products
Rubberand misc. 0.0128 0.103 0.00 1.95** 0.015 0.115 -0.031 0.021 0.015 -0.069
plastics products
Leathergoods and 0.0018 0.259 7.38** 81.98** 0.011 -0.084 -0.102 0.154a-0.018 -0.018
products
Cement and glass 0.0131 0.089 -0.64** 4.38** 0.298a -0.007 -0.113 0.032 0.126 0.014
products
Primarymetal 0.0078 0.098 0.87** 2.73** 0.222a 0.055 0.009 0.031 -0.035 -0.046
industries
Fabricatedmetal 0.0017 0.102 1.51** 11.25** 0.150a 0.140 -0.155a-0.080 -0.101 -0.098
products
Machineryexcept 0.0053 0.096 0.93** 2.29** 0.030 0.057 0.109 0.062 0.015 0.098
electrical
Electricand electronic 0.0149 0.092 0.26 1.79** 0.035 0.152a -0.091 0.021 -0.003 -0.058
equipment
Transportation 0.0052 0.069 -0.12 0.64 0.132 0.187a -0.095 0.048 0.002 0.069
equipment
Miscellaneous 0.0082 0.062 0.57** 0.44 -0.007 0.090 -0.061 -0.083 0.001 0.001
manufacturing
Transport/ 0.0154 0.071 -0.78** 2.76** 0.180a 0.052 0.008 -0.043 -0.006 -0.097
communication/
utilities
Wholesale/retailtrade 0.0052 0.076 0.20 4.31 0.084 -0.016 -0.188a 0.027 0.025 0.089

Journal of International Business Studies

 Pricing of exchange risk in emerging stock markets andBMajerbi
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379

Table 1 Continued
Mean S.d. Skewness Kurtosis Autocorrelations

P P2 P3 P4 Ps P6

Finance/insurance/real 0.0032 0.080 0.07 1.28** 0.111 0.067 -0.106 -0.012 -0.119 -0.116
estate
Services 0.0067 0.091 -0.35 2.24** 0.081 0.168a -0.002 0.077 -0.026 -0.070
Other/diversified 0.0045 0.087 -0.61** 2.32** 0.1 85a 0.080 -0.043 -0.041 0.008 -0.103

Panel D Firm-leveldata No. of No. of % of total Meanc S.d.c % of total

firmsin firmsin market marketcap.d
sample databaseb cap.b

Argentina 14 24 74.2 0.0449 0.323 52.9

Brazil 16 26 80.4 0.0391 0.327 50.0
Chile 17 30 79.4 0.0276 0.126 56.8
Mexico 14 24 80.4 0.0327 0.170 46.4
India 14 25 79.8 0.0124 0.147 36.7
Korea 16 25 80.5 0.0184 0.166 37.2
Thailande 14 29 82.5 0.0173 0.188 49.2
Total 105
alndicates significant autocorrelation.
bAsof January1985.
cAveragefor all firms in a given country.
dAveragefor all firms in a given country over the sample period (1985-1999).
eSample period starts in January1989.
All returnsare expressed in US dollar and are computed in excess of the 1-month eurodollardeposit rate. Country returnsdata are computed from
national stock market indices, inclusiveof dividends and availablefrom DataStream.The world market returnis computed from the MSCIWorld Index
inclusiveof dividends. The EMcomposite index is the S&P/IFCEmergingMarketsComposite total returnindex. Portfoliono. 1 for each country includes
all listed firmswith the smallest quartilesize while portfolio no. 4 includes all listed firmswith the largest quartilesize in the country. Industryportfolios
are diversifiedacross all marketsof the S&P/IFCdatabase. ** and * indicate statisticalsignificance at the 1 and 5% levels, respectively.

American region. The excess skewness and kurtosis
at all data levels confirm the established evidence of
non-normal distribution of asset returns in EMs
and, in addition to the presence of significant
autocorrelation levels, justify the use of robust
standard errors using the Newey-West methodol-
ogy as described in the previous section. Table 2
provides summary statistics for the real exchange
rates used to construct the common and idiosyn-
cratic exchange risk components. It is not surpris-
ing to observe that on average, over the sample
period, the local currencies (LCs)of most countries
in this study depreciated in real terms against the
dollar. This is also confirmed by the negative
percentage change in the value of the EM currency
index. Table 2 also shows that the presence of
autocorrelation and heteroskedasticity in the real
exchange rate series needs to be properly accounted
for in the models estimation.
LC vs US dollar returns
We first proceed to a preliminary statistical analysis
in order to evaluate the extent of currency risk that
an investor might face when investing in an
emerging stock market index. More precisely,
taking the US investor's perspective, we try to
determine how nominal exchange rate changes
affect the dollar-denominated return, and what
component of this dollar return comes from
currency fluctuations relative to the realized market
return in the LC.
Table 3 shows the means and s.d. for the
historical returns expressed in US dollars (US$)
and LCs for the nine EMs covered in the study. A
few points are noteworthy. First, historical returns
in LCs are on average much higher than the
corresponding dollar returns for all countries. For
some countries, mainly in Latin America, the mean
return is reduced to less than half, once translated
into US$. This is due to the negative impact of
currency changes that characterizes all countries
over the sample period. The variability of the
dollar-denominated returns is usually higher than
the variability of the corresponding returns
expressed in LC for almost all countries. The
obvious explanation for this excess variability of

Journalof InternationalBusinessStudies
 Pricing of exchange risk in emerging stock markets andB Majerbi
FCarrieri
380

Table 2 Summarystatisticsfor real exchange rate changes

Mean S.d. Skewness Kurtosis Autocorrelations

P P2 P3 P4 P5 P6

Argentina 0.204 14.518 -2.99** 34.28** -0.207a 0.113 -0.181a -0.064 -0.009 -0.017
Brazil -0.105 4.839 -3.26** 43.40** 0.144a -0.117 -0.037 0.022 0.045 0.035
Chile -0.110 3.999 -7.57** 98.50** -0.018 0.025 -0.108 0.180a -0.036 -0.006
Mexico -0.073 6.597 -5.24** 38.79** 0.000 -0.123a 0.000 -0.090 0.013 -0.057
Greece -0.006 3.314 -0.76** 2.39** -0.062 -0.013 0.021 -0.153a 0.085 -0.041
India -0.261 2.358 -2.75** 18.61** 0.021 0.028 0.020 0.009 0.001 -0.117
Korea -0.071 3.227 -4.82** 56.12** 0.052 0.052 -0.081 -0.097 -0.015 0.089
Thailand -0.156 3.006 -0.60** 33.54** 0.131a -0.124a 0.016 -0.079 0.111 0.066
Zimbabwe -0.405 4.665 -2.45** 16.15** 0.239a -0.050 -0.022 0.027 -0.032 -0.250
EMcurrency index -0.086 1.184 1.31** 4.78** 0.187a 0.099 -0.055 -0.042 0.072 0.064
Broadcurrency index -0.014 1.319 -0.01 0.47 0.323a 0.056 0.032 -0.062 -0.034 0.007
The datafor the countriesreferto the percentagechangein the realexchangeratescomputedusingnominalbilateralexchangeratesof the local
with respectto the USdollarandthe changein the country'sCPIrelativeto the CPIof the US.Nominalexchangeratesand CPIseriesare
currencies
providedby IMF'sInternationalFinancialStatistics
and availablefromDataStream.The EMcurrencyindexis the realtrade-weighted 'otherimportant
tradingpartners'(OITP) indexof the USdollarcomputedby the FederalReserveBoardandwhichincludes19 emergingmarketscurrencies. Thebroad
currencyindexis the realtrade-weighted'broad'indexof the USdollar,which,in additionto the emergingmarketscurrencies,includes16 major
currenciesuntilthe introductionof the euroand seven currenciesafterthat event. **and *indicatesstatisticalsignificanceat the 1 and 5% levels
and a indicatessignificantautocorrelation.
respectively,

Table 3 LCvs US$-denominatedreturns(January1976-October 1999)

Returnsin LC Returnsin US$ App/dep. of LCvs US$

Mean(%) S.d. (%) Mean(%) S.d.(%) Mean(%) S.d. (%)

Argentina 12.41 36.47 4.44 25.93 -6.02 11.77

Brazil 11.98 22.69 1.94 16.16 -8.52 9.40
Chile 3.87 10.34 2.42 10.56 -1.38 3.32
Mexico 4.15 11.27 1.99 12.32 -2.08 5.83
Greece 1.96 9.82 1.22 10.01 -0.71 2.99
India 1.93 8.23 1.36 8.09 -0.53 2.12
Korea 1.73 9.94 1.53 11.09 -0.27 3.04
Thailand 1.44 9.66 1.27 10.08 -0.18 2.94
Zimbabwe 2.33 9.57 0.99 10.46 -1.35 3.83
LCrefersto localcurrency;US$refersto USdollar.
The lasttwo columnsprovidethe meansand standarddeviationsof the changein localcurrencyvalueswith respectto USdollarbasedon nominal
exchangerates.

returns when expressed in dollar is the effect of
exchange rate changes.
As shown in Table 3, the dollar has on average
appreciated in nominal terms against all of the nine
LCs over the sample period. This seems consistent
with the lower returns observed when expressed in
dollar terms, because potential gains in returns are
reduced by the depreciation of the LCs. Although
exchange rate variability is quite low on average
compared with the volatility of market returns in
LC, its impact on the dollar returns is significant.
It is clear from Table 3 that exchange rate
variability affects both the realized returns and
the volatility of an investment in a foreign stock
market. To determine the extent of the contribu-
tion of the exchange rate volatility in the total
variance of the dollar-denominated returns, we
perform a variance decomposition analysis similar
to Eun and Resnick (1988). Theoretically, we can
decompose the variance of the dollar returns into
three components:
(1) the pure variance of the corresponding returns
in LC;
(2) the variance of the exchange rate returns, AS;
and
(3) component related to the covariance of the LC
a
returns and exchange rate changes.21
As shown in Table 4, the variance of the dollar-
denominated returns is higher than the variance of

Journal of International Business Studies

 Pricing of exchange risk in emerging stock markets
FCarrieri
Table 4 Variancedecomposition of the US$-denominatedreturns
Var(Rus) Var(RLC)
Argentina 672.14 1329.80
Brazil 261.11 514.62
Chile 111.48 106.82
Mexico 151.78 126.99
Greece 100.17 96.36
India 65.61 67.79
Korea 123.21 98.86
Thailand 101.71 93.23
Zimbabwe 109.37 91.57
Rusrefersto the monthlyreturnsdenominatedin USdollars;RLCis the returnin localcurrency;
of localcurrencieswithrespectto the USdollar.Thelastcolumnrepresentsthe contribution of the varianceof nominalexchangeratechangesto the
totalvarianceof the marketreturnsdenominatedin dollar.
returns in LC for all countries except Argentina and
Brazil. Exchange rate variability can be seen as
affecting the dollar-realizedreturn through both its
own variance and its covariance with the local
market returns.
The total contribution of the exchange rate
changes to the variance of the dollar returns can
be calculated as the percentage difference between
the variance of the LC-denominated returns and
the dollar-denominated returns variance. The
results are shown in the last column of Table 4.
We can see that exchange rate volatility has on
average caused an increase of up to 25% in the
variance of some market returns when translated
into US dollars, as in the case of Korea.The result is
somehow different for Argentina and Brazil as the
exchange rate variability reduced on average the
variation of the dollar-denominated returns.
Although the exchange risk contribution as calcu-
lated above is low on average for some markets
(e.g., Chile, Greece, India), a subperiod analysis
reveals that the currency risk contribution for
these countries can reach up to 40% in some
periods.22
Asset pricing tests results
Estimation of the two-factor model
We estimate the model in Eq. (4) using first
aggregate market-level returns and then different
cross-sections of portfolio returns and firm-level
returns. The assets sensitivities to the world and
exchange risk factors are jointly estimated with the
corresponding risk premia using the iterated GMM
procedure as described earlier. For the two-factor
model, as previous studies on currency exposure
andBMajerbi
381
Var(dS) Cov(RL, d S) dS contrib. (%)
138.62 -202.47 -49
88.34 -93.85 -49
11.02 -0.36 4
34.03 -2.82 20
8.91 -1.58 4
4.48 -0.21 -3
9.22 6.41 25
8.64 0.14 9
14.67 4.04 19
ASrepresents
the changein the nominalexchangerates
and risk pricing have shown that asset-specific
exchange rate measures perform better in empirical
estimation, we use the change in the real EM
currency index as the exchange risk factor that is
more relevant for the countries covered in our
study.23Panels A of Tables 5-7 report the results of
this estimation.
Table 5, Panel A, reports the estimated betas and
risk premia parameters in the two-factor model
using the cross-section of excess market returns.
First, as indicated by the J-test, the two-factor
model cannot be rejected at any statistical signifi-
cance level. The betas with respect to the world
market index in the first column of Panel A vary
from -0.04 for India to 0.89 for Mexico. They are
mostly positive (except for India), and are signifi-
cant for six out of nine countries. The exchange risk
betas are generally larger than the world market
betas for all countries. They vary from 0.46 for
Zimbabwe to 3.18 for Argentina. The estimated
coefficients are highly significant for Argentina,
Chile, Mexico, India and Thailand. The positive
sign on the exchange risk beta coefficients indicates
that the foreign countries assets are expected to
yield higher dollar excess returns when the dollar
depreciates.24 The estimated world market pre-
mium of 0.11% is not statistically significant on
average over the sample period. The exchange risk
factor, however, yields an unconditional monthly
risk premium of 0.73%, which is highly significant.
This evidence is different from that obtained in
previous studies testing unconditional asset pricing
models with market-level data for major developed
countries. For instance, the studies by Dumas and
Solnik (1995) and Ferson and Harvey (1999) both
found that exchange risk premia were insignificant
Journal of International Business Studies
 Pricing of exchange risk in emerging stock markets
382
compared to the world market risk premium within
their IAPMsthat assume full integration.
As theoretical asset pricing models include all
world currencies as risk factors, we also test our two-
factor model using the broad currency index as an
alternative measure for the exchange risk factor to
account for the effect of major currencies fluctua-
tions. With this measure, the estimated exchange
risk premium over the whole sample period
decreases to 0.54% and is significant only at
10%.25 In addition, as EMs are characterized by
periods of turbulence, we investigate the impor-
tance of the currency premium over subperiods. In
particular,we look at the 1994-1999 period, which
is characterized by various crises in EMs, starting
from the Tequila crisis in Mexico, to the Asian Flu
and the Russian default. The estimated premium
using the EM currency index over this subperiod is
-0.97% (-0.49% with the broad currency index)
and is also significant at 1% for both exchange rate
measures. Although a different sign for the esti-
mated premium is an indication of time-varying
risk premia, its significance across subperiods still
justifies the use of an unconditional model for the
whole sample.
Next, we estimate Eq. (4) using portfolio returns
constructed from all securities covered by the S&P/
IFC's database for our sample of nine EMs. Four
groups of portfolios are constructed for each
country with quartile-size1 including the smallest
size firms and quartile-size4 the largest size firms.
Panel A of Table 6 summarizes the results of the
two-factor model using cross-sections of value-
weighted portfolio returns across the nine EMs for
each size group. We report estimates of the factors
risk premia, the average pricing errors, the RMSE
and the adjusted R2 across portfolio groups.26 The
average exchange risk premium related to the EM
currency index is highly significant for portfolios of
sizes 2-4 and statistically insignificant for the
smallest size group 1. Interestingly, the size of the
estimated exchange risk premium tends to increase
with portfolio size (from -0.43% for the smallest
size 1 to 1.75% for the largest size 4). Although we
have no information on the nature of operations of
the firms included in each quartile nor on the
extent of their foreign activities to explain such
findings, the results still suggest that, on average,
larger size firms are those that explain the pricing of
foreign exchange risk in emerging stock markets.
When the broad currency index is used for the
exchange risk factor, the evidence is inconclusive.
The exchange risk premium is significant only for
Journal of International Business Studies
FCarrieri
andB Majerbi
size 3 portfolios, with size 1, 2 and 4 portfolios
yielding large but insignificant exchange risk pre-
mia.
For comparison with previous studies that
use industry portfolio returns, we also estimate
Eq. (4) using 24 portfolio returns computed
from the IFC'sindustry indices for all EMs. Results
of this estimation are reported on the last row of
Table 6. It is interesting to note that, whereas
studies such as Jorion (1991) failed to find any
significance of the exchange risk premium using
cross-sections of 20 industry portfolios for the US
market, the exchange risk premium obtained in
this study from the cross-section of EMs industry
portfolios is highly significant.27 This result also
holds when we use the broad currency index. Thus,
also in the case of cross-currency diversified
portfolios, we find that currency risk is a significant
priced factor, even though the size of the estimated
risk premium is reduced compared with that
obtained at the market-level tests or the size-based
portfolios.
Finally, we estimate Eq. (4) using firm-level data
separately for each country to determine whether
exchange risk premia vary across countries/
regions.28 Differently from our previous setup,
which included a cross-section of country indices
(or country-size portfolios), we are looking at the
relevance of exchange risk pricing using a cross-
section of local stocks. Table 7, Panel A, summarizes
the estimated risk premium coefficients for the
world and exchange risk factors for each country.29
The evidence is quite mixed and suggests important
variations of the average exchange risk premium
across countries and regions. In Latin America,
Brazil,Chile and Mexico show large and significant
exchange risk premia with respect to the EM
currency index. For Argentina, the exchange risk
premium is marginally significant and negative in
this two-factor model. For Asian countries, the
currency factor yields generally lower risk premia
that are negative and significant for Korea, insig-
nificant for India, while Thailand has a marginally
significant and positive exchange risk premium.
The world market premium is generally positive
and significant for all countries except Chile and
Thailand.30 In all our tests the J-test cannot reject
the model, although the evidence is not very
strong. When we use the broad currency index,
the estimated exchange risk premium is less
significant both for Latin American firms and for
Korea, but becomes more significant for firms in
India.
 Pricing of exchange risk in emerging stock markets
Estimation of the four-factor model
As explained earlier, we test for the pricing of
exchange risk under a partial segmentation hypoth-
esis by estimating model (5), where both market
and exchange rate risks are decomposed into
common and idiosyncratic components. For mar-
ket- and portfolio-level tests, we use the residual
from a regression of the EM composite market
return on the world market return as a measure of
idiosyncratic market risk that is specific to the EMs
countries. As a measure of the common exchange
risk factor we use the change in the real broad
currency index, because the model now includes an
idiosyncratic exchange risk factor that is specific to
the countries in the study. For market- and
portfolio-level tests where we use multi-country
data, the idiosyncratic exchange risk factor is
constructed as an average of the residuals of each
of the countries' real bilateral exchange rates
projected on a constant and the common exchange
rate, similar to Vassalou (2000). For firm-level tests,
the idiosyncratic market and exchange risks are
replaced by the country-specific local market return
(orthogonal to the world market return) and the LC
real bilateral exchange rate (orthogonal to the
broad currency index) respectively.
Panels B of Tables 5-7 summarize the estimated
risk premium parameters in the four-factor model
at the different data levels. Similar to the previous
setting, the model cannot be rejected at any
significance level based on the J-test for over-
identifying restrictions. However, the four-factor
model seems to provide a better specification than
the two-factor model at all data levels. Compared
with what was obtained in the two-factor model
(Panel A) we observe a reduction in the APEand in
the RMSE.For example, in the case of the market
index for Brazilin Table 5, the APEin the two-factor
model is 8.28% (0.0069 x 12 x 100) per annum
(p.a.), which is still half the size of the average
realized return in Table 1 (15.48% p.a.), while the
APEfor the four-factormodel is 1.56% p.a. and thus
economically small. Similar reduction in size is
observed for the other assets. Especially for the
firm-level data, the APEs in the four-factor model
are an order of magnitude smaller than those in the
two-factor model and, with an average size of
1.05% p.a. across all firms in all countries, they
are not economically significant. Similarly, the
RMSEof the four-factor model contributes to larger
reduction in the standard deviation of the assets. In
the case of Brazil, the RMSE of the four-factor
model is 0.152 or 52.6% p.a., while the RMSEin the
andBMajerbi
FCarrieri -"
383
two-factor model is 55.4% p.a. As the s.d. of the
average return is 56.11% p.a., the four-factor model
is more effective at reducing the volatility of the
asset.
The adjusted R2 are also higher at all data levels.
The most important improvement in the adjusted
R2 is obtained for the firm-level tests (Table 7) with
the addition of local market and local exchange risk
factors.31Thus, overall, the evidence in favor of this
specification is much stronger than what is
obtained in the two-factor model.
For the market-level returns as well as the
different cross-sections of size-based portfolios, the
model improvement is driven mostly by the
importance of the idiosyncratic market factor,
which yields a large positive and highly significant
risk premium in almost all cases. However, the
significance level of the exchange risk factor is less
strong than what is documented in the two-factor
model (Panel A), and in some cases, particularly at
the market-level returns, it is totally subsumed by
the local market factor (Panel B of Table 5). For
portfolio-level tests, the common exchange risk
factor remains significant only in size 2 portfolios
and is marginally significant for portfolios of size 3,
while the idiosyncratic exchange risk is never
significant. This result suggests that, using aggre-
gate market or portfolio returns, it is difficult to
detect an unconditional exchange risk premium
when the model allows for partial segmentation.
Indeed, local market idiosyncratic risk tends to
subsume all components of currency risk, while a
common exchange rate factor is significant in the
full integration model. This could be an indication
that, for EMs, exchange rate risk at the aggregate
level may actually be proxying for other sources of
local risk correlated with the exchange rates.
Interestingly, the results for the industry portfolios
that are diversified across all EMs are quite
different. In this case, the common exchange risk
factor is not subsumed and remains highly sig-
nificant in addition to the idiosyncratic market risk
factor.32
The results from the firm-level analysis confirm
the importance of the idiosyncratic or local market
risk in pricing emerging market assets. However,
with the exception of Chile and Thailand, we find
that at least one of the components of the exchange
risk often remains a significant pricing factor even
when the model allows for competing local sources
of risk. In particular,the idiosyncratic exchange risk
factor is highly significant for four countries out of
seven. The common exchange risk component
Journal of International Business Studies
 q: Pricing of exchange risk in emerging stock markets F Carrieri
andB Majerbi
384

Table 5 Asset pricing tests using market level data (1976-1999)

PanelA: Two-factormodel
rit = fiwrwt + lisSt + /W3iw + jS/3is + Eit

Country #w APE RMSE Adj-R2

/s
Argentina 0.147 3.181*** 0.0146 0.258 0.21
0.385 2.551
Brazil 0.555*** 0.743* 0.0069 0.160 2.04
2.594 1.228
Chile 0.238 1.819*** 0.0042 0.104 3.21
1.279 4.576
Mexico 0.892*** 1.732*** -0.0001 0.116 10.91
3.622 3.245
Greece 0.512*** 0.649* 0.0004 0.098 4.46
3.768 1.517
India -0.044 1.216*** -0.0016 0.080 2.20
-0.347 3.145
Korea 0.723*** 0.731 0.0027 0.106 7.87
4.646 1.151
Thailand 0.703*** 1.457*** -0.0052 0.094 12.65
3.455 3.558
Zimbabwe 0.41 6** 0.460 -0.0004 0.103 2.31
2.107 0.946

.w is J-stat

0.110 0.727*** 5.814

0.167 2.523 [0.562]
Panel B:Four-factormodel
/it= #iw wt +- # +-isst t + iste+w e
+ ?#iw -'ei+m + s3is + 'sfis + it

Country 3w es /ie APE RMSE Adj-R2

e
Argentina 0.247 1.160*** -0.500 1.140* 0.0087 0.246 9.79
0.853 5.457 -0.455 1.441
Brazil 0.597*** 0.634*** 0.617 -1.430*** 0.0013 0.152 11.63
2.968 3.786 1.077 -2.624
Chile 0.252** 0.728*** 0.090 0.372* 0.0003 0.093 23.07
1.865 9.887 0.254 1.351
Mexico 1.018*** 0.683*** -0.904 0.589** -0.0014 0.107 24.77
4.625 5.289 -1.217 1.655
Greece 0.429*** 0.228** 0.457 0.296* 0.0014 0.097 7.36
3.125 2.13 1 1.275 1.340
India -0.070 0.260*** 0.790** 0.129 0.0010 0.078 5.98
-0.531 3.409 1.908 0.690
Korea 0.705*** 0.1 79** 0.099 0.473* 0.0061 0.106 9.00
4.398 1.820 0.181 1.358
Thailand 0.672*** 0.470*** 0.676* 0.346* -0.0031 0.090 19.50
4.029 3.996 1.448 1.350
Zimbabwe 0.369** 0.303*** 0.012 0.551* -0.0035 0.100 7.92
1.696 3.144 0.021 17.507

I-stat
-0.304
w1e. 2.437*** -0.070 0.112 3.006
-0.494 3.155 -0.165 0.216 [0.699]
Panel A reports the results of the two-factor model, where ritis the excess returnon country i at time t; is the world market excess return;st is the
rwt
change in the real EMcurrency index; fliwand are the asset sensitivitiesto the world and exchange riskfactors respectively;and 2, and are the
Pi,s 4s
corresponding expected riskpremia. In Panel B, st refersto the change in the real broad currencyindex used as a measure of the common exchange risk
factor; s' refersto the idiosyncraticexchange risk,and is computed from the average of the residualsfrom regressionsof the nine countries' real bilateral
exchange rates on the broad currencyindex and a constant; re,, is the idiosyncraticmarketriskfactor obtained from the residualof the projection of the
EMcomposite marketreturnon the world market returnand a constant; f3,, and f are the asset sensitivitiesto the idiosyncraticmarketand exchange
riskfactors respectively;and and are the corresponding riskpremia. Estimatesof the riskpremia (I) are reported in percentage terms. t-values (in
2e 4e
italic) are corrected for heteroskedasticityand autocorrelation(using Newey-West estimatorswith truncation parameter q=6). P-valuesof the I-test are
between brackets.*, **, ***denote statisticalsignificance at the 10, 5 and 1% levels, respectively.APEand RMSEdenote, respectively,the mean pricing
errorand the root mean-squared errors.Adj-R2is the adjusted coefficient of determination. All returnsare in US dollars and all factors are de-meaned.

Journal of International Business Studies

 Pricing of exchange risk in emerging stock markets andB Majerbi
FCarrieri
385

Table 6 Asset pricing tests using portfolio level data (1976-1999)

Panel A: Two-factormodel
rit = fiwrwt+ fisst + Qwliw+
?s/is +
-rit
Size portfolios Iw as J-stat APE RMSE Adj-R2

Quartile size 1 2.974** -0.427 8.212 0.0033 0.165 2.20

1.974 -0.929 [0.314]
Quartile size 2 -0.016 1.229*** 8.112 0.0008 0.150 4.08
-0.015 2.697 [0.323]
Quartile size 3 0.431 1.291*** 5.990 0.0009 0.144 4.37
0.484 3.191 [0.541]
Quartile size 4 0.153 1.752*** 10.469 0.0026 0.137 3.98
0.131 3.532 [0.164]
Industry portfolios (period:1985-1999) 3.22*** -0.767*** 11.625 0.0003 0.096 12.71
4.774 -3.144 [0.965]

Panel B: Four-factormodel
rit = #iwrwt + + +
emremt isSt #Pse +wiww+ e- +sis + # + Eit
+m s?
Size portfolios s Ie APE RMSE Adj-R2
,w ge J-stat
Quartile size 1 1.510 1.664 -2.172 0.123 2.098 0.0003 0.161 7.14
0.705 1.037 1.249 0.154 [0.835]
Quartile size 2 0.330 3.128*** -0.714* 0.134 3.421 0.0006 0.145 9.84
0.437 3.903 -1.451 0.230 [0.635]
Quartile size 3 0.549 1.995* 1.779** 0.769 2.952 0.0000 0.138 11.58
0.516 1.526 1.954 1.065 [0.707]
Quartile size 4 1.784* 5.358*** -1.174 -2.238 5.497 0.0007 0.132 10.72
1.548 2.674 -0.752 - 1.025 [0.358]
Industry portfolios (period:1985-1999) 1.919*** -0.560** -0.615*** 0.025 13.010 0.0011 0.080 41.38
4.062 -1.643 -2.632 0.065 [0.877]
Panel A reports the resultsof the two-factor model, where ritis the excess returnon portfolio i at time t; is the world marketexcess return;st is the
rwtfactors respectively;and ), and Asare the
change in the real EMcurrency index; /i, and Pi, are the assets sensitivitiesto the world and exchange risk
corresponding expected riskpremia. In Panel B, st refersto the change in the real broad currencyindex used as a measure of the common exchange risk
factor; s' refers to the idiosyncraticexchange risk computed from the average of the residualsfrom regressions of the nine countries' real bilateral
exchange rates on the broad currencyindex and a constant; ,,t is the idiosyncraticmarketriskfactor obtained from the residualof the projectionof the
EMcomposite market return on the world return and a constant; flt and /4 are the asset sensitivitiesto the idiosyncraticmarket and exchange risk
factors respectively;and and 4fare the corresponding riskpremia. Estimatesof the riskpremia (1) are reported in percentage terms. t-values(in italic)
,emt
are corrected for heteroskedasticity and autocorrelation(Newey-West estimators with truncation parameter q=6). P-valuesof the ]-test are between
brackets.*, **, ***denote statisticalsignificance at the 10, 5 and 1% levels, respectively.APEand RMSEdenote, respectively,the mean pricingerrorand
the root mean-squared errorsacross portfolios. Adj-R2is the adjusted coefficient of determination computed as averages across portfolios.

from the broad currency index remains highly
significant only for Brazil, while it yields a margin-
ally significant risk premium for Korea.Finally, it is
interesting to note that, for India, the idiosyncratic
exchange risk premium is now significant at the 5%
level whereas in the two-factor model we failed to
detect any significance of the exchange risk factor
using an aggregate currency index measure. This
result is consistent with some studies showing that
bilateral exchange rate measures may be better than
aggregate measures when testing for exchange risk
pricing in an unconditional setting.33
This evidence is not surprising, given the firm-
specific nature of foreign exchange risk exposure
and the different economic structures of coun-
tries.34We should note, though, that because of the
limited number of firms included in our tests, we
should be cautious in making strong conclusions
from this firm-level analysis.
Finally, to check the robustness of our results
from the four-factor model, we re-estimate the
model at all data levels substituting the EM
currency index for the broad currency index as a
measure of the common exchange risk factor.
Overall, the results remain fairly similar in that at
least one of the components of the exchange risk
factor yields a significant risk premium for most
countries, even in the presence of a highly
significant local market factor. However, we find
that when we use the EM currency index, the

journalof InternationalBusinessStudies
-)? Pricing of exchange risk in emerging stock markets andB Majerbi
FCarrieri
386

Table 7 Asset pricing tests using firm-level data (1985-1999)

Panel A: Two-factormodel
rit = + + ;4wiw + S/ is + it
iwrwt flisst

Country J-stat APE RMSE Adj-R2

•w is
Argentina 8.550** -0.879* 4.420 0.0144 0.322 -0.12
1.870 -1.410 [0.975]
Brazil 2.403*** 1.085*** 10.987 0.0087 0.324 1.48
2.883 4.327 [0.687]
Chile -0.299 1.350*** 7.220 0.0045 0.125 2.15
-0.464 4.670 [0.951]
Mexico 2.130** -1.230*** 6.640 0.0056 0.165 5.75
2.3 10 -2.750 [0.880]
India 3.160*** -0.250 11.600 0.0082 0.145 0.99
3.620 -0.959 [0.477]
Koreaa 1.346** -0.389** 8.781 0.0012 0.164 6.93
1.875 -2.201 [0.845]
Thailanda 0.051 0.171* 3.690 0.0045 0.174 14.88
0.106 1.240 [0.988]

Panel B Four-factormodel
rit
= ?
iwrwt + + isst + + + + As/is Asfi +
mrt piesS -+- 8it
iwwiw Ami/m
Country J-stat APE RMSE Adj-R2
i.wAm is is
Argentina 7.167* 3.400*** 1.066 -9.270** 3.998 0.0011 0.170 71.30
1.289 4.381 1.077 -1.660 [0.947]
Brazil 4.399*** -0.986 0.853*** -2.151** 10.636 0.0029 0.255 42.43
3.144 -0.698 2.566 -2.152 [0.560]
Chile -1.133** 2.798*** 0.056 -0.351 11.295 -0.0001 0.097 39.91
- 1.935 9.237 0.3 77 -0.593 [0.586]
Mexico 3.479** -3.956** 0.034 3.040*** 4.618 0.0005 0.151 21.22
1.699 -1.607 0.075 2.184 [0.915]
India 2.618 0.875** 0.706 -7.186** 4.684 0.0003 0.109 43.78
1.309 2.061 0.723 -1.794 [0.911]
Koreaa -4.333 6.651** 3.399* 0.717 6.986 -0.0010 0.11 57.27
-1.182 1.705 1.562 0.571 [0.858]
Thailanda 0.216 0.867 0.206 -0.202 3.759 -0.0002 0.124 52.74
0.300 0.8 13 0.926 -0.566 [0.958]
aData for Koreastart in January1986 and for Thailandin January1989.
PanelA reportsthe resultsof the two-factor model, where ritis the excess returnon firm i at time t; rw, is the world marketexcess return;st is the change
in the real EM currency index; li, and pli,are the assets sensitivities to the world and exchange risk factors respectively; and ?., and )s are the
corresponding expected riskpremia. In Panel B, st refersto the change in the real broad currencyindex used as a measure of the common exchange risk
factor; s' refersto the idiosyncraticexchange riskmeasured by the residualfrom a regression of the local currency real bilateralexchange rate on the
broad currencyindex and a constant; Prt is the idiosyncraticmarketriskfactor obtained from the residualof the projectionof the local marketreturnon
the world returnand a constant; fm, and /f are the asset sensitivitiesto the idiosyncraticmarketand exchange riskfactors respectively;and ,eand ,,'are
the corresponding riskpremia. Estimatesof the riskpremia (/) are reported in percentages. t-values (in italic) are corrected for heteroskedasticityand
autocorrelation (Newey-West estimators with truncation parameter q=6). P-values of the J-test are between brackets. *, **, *** denote statistical
significance at the 10, 5 and 1% levels, respectively.APEand RMSEdenote, respectively,the mean pricingerrorand the root mean-squarederrorsacross
assets. Adj-R2is the adjusted coefficient of determination computed as averages across firms for each country.

premium attached to the common exchange risk emerging stock markets. The results, however, are
factor often remains more significant than that of sensitive to the model specification and the data
the idiosyncratic exchange risk factor for most aggregation level. For instance, using market-level
countries. returns, exchange risk seems to be priced but is
Overall, the evidence in this study shows that, subsumed by the idiosyncratic market factor in a
unlike in some tests for major developed markets, model specification that accounts for segmenta-
exchange risk is often unconditionally priced in tion. Thus, at the aggregate level, exchange rate risk

Journal of International Business Studies

 Pricing of exchange risk in emerging stock markets
might be proxying for other sources of risk. Our
firm-level analysis instead shows that, even after
properly accounting for both common and idiosyn-
cratic market and exchange risk components, both
local market risk premium and local exchange risk
premium are significant determinants of stock
returns.35The results, however, differ across coun-
tries with respect to the relative significance and
magnitude of the risk premia attached to the local
vs the exchange risk factor.
Conclusions
In this paper, we provide new empirical evidence
on the pricing of exchange risk in emerging stock
markets. As the importance of exchange rate risk for
EMsis likely to be different from that for developed
markets, we use an unconditional framework to
investigate whether exchange risk represents, on
average over the long run, an important compo-
nent of expected equity returns. To our knowledge
there is no previous study that investigates this
issue for a large number of EMs across different
regions and different exchange rate regimes. Our
tests are conducted at the market-, portfolio- and
firm-level data and use real exchange rate specifica-
tions to fully account for the effects of PPP
deviations. In addition, we account for idiosyn-
cratic market and exchange risks that could be
more relevant in a partially segmented market
structure. This also allows different components
of the exchange risk to compete with other sources
of local risk that may be related to economic and
political factors in these countries.
Our results support the hypothesis that exchange
risk is globally priced and commands a significant
unconditional risk premium in emerging stock
markets. This finding is different from what has
been shown in unconditional studies for most
major developed stock markets, where the hypoth-
esis of a zero exchange risk premium could not be
rejected in a model of full integration. The
estimated exchange risk pricing coefficients are
generally higher than those estimated in similar
frameworks for developed markets and, with cross-
sectional data at the firm level, there is indication
that the size and sign of exchange risk premia vary
across countries and regions.
However, in this unconditional setting, the
significance of exchange risk factor is often affected
by the model specification. Indeed, in an enlarged
pricing model that accounts for segmentation, we
find evidence at the aggregate market level that the
most relevant factor is the idiosyncratic local
FCarrieri
andB Majerbi
387
market risk, which subsumes both the common
and idiosyncratic components of exchange risk. At
the less aggregated portfolio-level data, the evi-
dence is mixed. We find a marginally significant
common exchange risk factor for larger size
portfolios while a cross-section of industry portfo-
lios diversified across all EMs yields a highly
significant exchange premium despite the presence
of a significant local market factor.At the firm level,
although the importance of the local market is also
confirmed, some measures of exchange rate risk,
particularlythose related to more specific emerging
market currencies, remain highly significant for
most countries.
Overall, these results have important implica-
tions for the investment and risk management
decisions of corporations. Pricing of exchange rate
risk implies that exchange rate exposure is partly
non-diversifiable and investors require compensa-
tion from taking on this type of risk. In this case,
hedging by companies will be rewarded with a
lower cost of capital. In addition, an appropriate
model specification that takes into account both
exchange risk and local market risk as separate
pricing factors seems necessary for emerging mar-
ket assets.
Acknowledgements
We are grateful to Jose Manuel Campa (the Depart-
mental Editor),John Doukas,Vihang Errunzaand two
anonymous refereesfor many helpful comments that
improved the paper. This paper has also benefited
from workshopsat McGillUniversity,LavalUniversity,
the 2001 EuropeanFinancialManagementAssociation
Meetings and the 2003 Applied Business Research
Conference. We thank S&P and Vihang Errunzafor
providingdata on individualsecurities.
Notes
'This is due to the low correlationwith developed
markets,in additionto the attractivefeaturesof higher
average returnsand higher returnspredictability.
2PPPdeviations are well documented in the eco-
nomic literature for both developed and emerging
markets (Roll, 1979; Abuaf and Jorion, 1990; Sale-
hizadeh and Taylor, 1999; Li, 1999).
3For an analysis of devaluations and stock market
returns in emerging markets see Glen (2002).
4The excess returns rit are computed as(Rit-Rft),
where Ritrefersto the gross returnon asset i at timet
and Rftis the 1-month US Treasury bill rate.
5Following Ferson and Harvey (1994), if we assume
a general beta pricing model for expected returns Ri,
journal of International Business Studies
 Pricing of exchange risk in emerging stock markets
388
such as E(Rit) o + @ - .j bii where bij are the
betas of the Rit on the k global riskfactors, then this
impliesan expressionfor the expected excessreturnsas
in Eq. (2) above, where flij= bjjbfare the betas of the
excess returnsand bfiare the betas of risk-freerate Rft.
6When factors are not de-meaned, they must
represent 'returns' and the model estimation may
requirethe use of mimickingportfolioswhose returns
are substitutedfor the factors (see Fersonand Harvey
(1994) for a more detailed explanation).
7ln estimating this two-factor model, as well as in
the four-factormodel that follows, all riskfactors have
been de-meaned as explained in the methodology
section above.
8The original specification of Adler and Dumas
(1983) includes all the currenciesof the countries in
the model. Forparsimony,previousstudies have used
aggregate proxies such as the trade-weighted
exchange rate in Jorion (1991) and Choi et al.
(1998) or the SDRin Choi and Rajan(1997).
91nAdlerand Dumas (1983), excess returnsshould
be related to their covariances with the foreign
inflation rates expressed in the reference currencyas
a measure of PPPdeviations. These terms have often
been replaced in empiricaltesting by the changes in
nominalexchange ratesbased on the assumptionthat
inflationrates are non-random,which may be reason-
able in the context of majordeveloped markets.
101ndeed,as shown in Vassalou (2000), although
both inflation risk and exchange risk are significant
pricing factors when considered separatelyin various
models, neither is significantwhen included jointly in
the same asset pricing model.
1 Forexample, Harvey(1995) shows that expected
returns in emerging markets are more likely to be
influenced by local ratherthan global factors.
12As shown in Vassalou (2000), the common
component exchange rate variableconstructed with
this methodology is highly correlatedwith an equally
weighted index of the differentcurrencies(correlation
of 0.991).
13Similarto the studies by Vassalou (2000) and
Ferson and Harvey (1994), we use iterated GMM
following Ferson and Foerster (1994), who showed
that such a procedure has superior finite sample
properties compared with a one-step GMM estima-
tion.
14The statistic is the minimized value of the
J-test
quadratic function in the GMM system, and follows a
x2 distribution when using an optimal weighting
matrix, as is the case in our estimation procedure.
15The Emerging Market Database contains a large
number of sector/industry indices. For comparison
journal of International Business Studies
FCarrieri
andB Majerbi
purposes we chose those ones that are similarto the
US industriesincluded in the Jorion(1991) study.
16These limitations appear in other papers on
emerging markets,for example Claessenset al. (1998).
17We are not aware of any study that specifically
looks at the impact of survivorshipbias on exchange
riskexposure or pricing.We believe that the impact of
survivorshipbias is either not substantialor it might
actuallyworkin our favor.Exchangerateexposureand
pricingare multifaceted.In particular,we do not have
knowledge or unidirectional expectations of the
exchange rate exposure of failed and merged firms.
As these are expected to be the high returnand low-
return firms, their omission should not substantially
impact our estimation.Additionally,because it is likely
that those firms that have survived have successfully
managed exposures, this might actually introduce a
downward bias in our pricingcoefficients,makingthe
rejectionof the null less likely.
18These countries are: Argentina, Brazil, Chile,
Colombia, Mexico, and Venezuela in LatinAmerica;
China, Hong Kong, India,Indonesia,Korea,Malaysia,
the Philippines,Singapore, Taiwan, and Thailand in
Asia; Israeland Saudi Arabiain the Middle East;and
Russiain EasternEurope.
g1Theseare the currenciesof the euro-areacountries
plus Australia,Canada, Japan, Sweden, Switzerland,
and the UK.
20Formore informationon these indexes, see the
FederalReserveBulletin,October 1998.
21As (1 + Ru$)=(l + RLC)x (1 + AS) we can write
Rus=RLc + AS+ RLCx AS. Therefore, the variance of
the dollar return can be written as Var(Rus)=
Var(RLc) + Var(AS)+ 2Cov(RLC, AS)+ another term to
account for the cross-product (RLc x AS).
22Resultsof the variance decomposition over sub-
periods are availablefrom the authors upon request.
23Forinstance, Choi et al. (1998) find that, when
using the bilateralJPY/US$exchange rate, the test
results support the hypothesis that exchange risk is
priced in both the unconditional and conditional
versions of the model. However, when the trade-
weighted exchange rate is used as a measure for the
exchange risk factor, the results are mixed, and the
significance of the exchange risk factor is confirmed
only in the conditional setting. In a similar vein,
Dominguez and Tesar (2001) found that many firms in
their sample, including some emerging markets, are
exposed to one or more bilateral exchange rates
included in the world exchange rate index but not to
the index itself.
24Allexchange rate changes used in testing models
(4) and (5) are computed such that a positive value
 Pricing of exchange risk in emerging stock markets
means an appreciation of the foreign currencies
against the US $ (the reference currency). Thus,
a positive exposure to this factor means that the
asset returns increase with a depreciation of the
dollar.
25Resultsof the two-factor model using the broad
currencyindex at all data levels are availablefrom the
authorsupon request.
261nthe rest of the tables, we do not report the
estimated betas as they are in general qualitatively
similarto those reported in Table 5. When important
differences are detected with respect to the sign or
magnitude of the estimated parameters,we shall refer
to them in our analysisof the results.
27Furthermore,the size of the exchange risk
premium estimated for industry portfolios in this
model (0.46%) is much higher than what was
obtained in Jorion's(1991) study, where the exchange
riskpremium (using a trade-weighted exchange rate
index) for the period of 1971-1987 was estimated at
0.033% for the US market.
28We should note that this firm-level analysis is
limited by the availabilityof returndata on individual
securitiesover a common long time periodfor a given
country. Thus, to increase the number of cross-
sections within a country, we had to shorten the
sample period and test the model over the period
starting from January1985 (or later for Korea and
Thailand).
29Greece and Zimbabwe are excluded from this
analysisfor lack of individualreturndata over the test
period.
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Appendix A
List of industries for firm-level data

SICcodes Industry ARG BRA CHI MEX IND KOR THAI

2 Agriculturalproduction:livestock
9 Fishing 2
10 Metalmining 4 1 1
13 Oil and gas extraction 2
14 Non-metallicminerals,except fuels 1
16 Construction:generalcontractors 1
20 Food and kindredproducts 2 2
21 Tobacco manufactures 1 1 1 1
22 Textilemill products 1
23 Appareland other textile products 1 5
24 Lumberand wood products 1
26 Paperand allied products 1 3 1 1
28 Chemicalsand allied products 1 1 1 2 2 1
29 Petroleumrefiningand relatedproducts 3 1
30 Rubberand misc. plasticsproducts 1
32 Cement and glass products 1 2 1 1 2
33 Primarymetal industries 1 2 1
34 Fabricatedmetal products 1 1 2 1 1
35 Machineryexcept electrical 1
36 Electricand electronicequipment 1 4
37 Transportation equipment 1 2 3
39 Miscellaneousmanufacturing 1
44 Watertransportation 1
45 Transportationby air 1 1
48 Communications 1 1
49 Electric,gas or sanitaryservices 2
50 Wholesaletrade:durablegoods 3
53 Generalmerchandisestores 2
60 Banking 2 4
61 Creditagencies other than banks 3
99 Other,diversifiedholding companies 1 1 2 1
Total 14 16 17 14 14 16 14

Journal of International Business Studies

 Pricing of exchange risk in emerging stock markets
About the authors
Francesca Carrieri is Associate Professorof Finance
at the Faculty of Management, McGill University,
Montreal, Canada. Her research focus is on inter-
national asset pricing and investment, with papers
published in ManagementScienceand the Journalof
Financialand QuantitativeAnalysis.
Basma Majerbi is an Assistant Professorof Finance
at the Faculty of Business, University of Victoria,
Acceptedby Jose Manuel Campa, DepartmentalEditor.This paper has been with the author for two revisions.
andBMajerbi
FCarrieri -
391
Canada. Her primary research interests are in
international finance, international asset pricing,
investments and risk management. Her current
research deals with the pricing of exchange risk in
emerging stock markets as well as the impacts of
emerging markets risks on the pricing of global
financial assets with papers published in the
Journal of Financial and QuantitativeAnalysis and
the Journalof EmpiricalFinance.
Journal of International Business Studies