Assessing the extent of exchange rate risk pricing in equity markets: emerging versus developed economies

Abstract

Purpose

This paper contributes to the literature on exchange rate exposure by assessing the extent to which exchange rate risk is priced in both African emerging and developed equity markets. It examines whether this risk leads to a premium or discount in market returns. The study uses the United States and South Africa as representatives for developed and emerging economies, respectively.

Design/methodology/approach

The paper employs two-factor and three-factor conditional CAPM approaches with a two-stage estimation process. In the first stage, time-varying risk exposures are derived using the ICAPM model estimated through rolling regression. In the second stage, the impact of these risk exposures, particularly exchange rate risk exposure, is assessed on stock market returns using Generalized Linear Model (GLM) regression.

Findings

Unlike previous studies that suggest exchange rate risk is not necessarily priced in the equity market due to hedging, this paper finds that exchange rate risk is indeed priced in both African and developed equity markets, albeit to different extents. The African equity market demands a higher premium compared to the developed equity market.

Practical implications

The findings of this paper have significant implications for policymakers, asset managers, and investors. They provide insights for making more informed decisions, implementing effective risk management strategies, and fostering a more stable and appealing investment environment.

Originality/value

To the best of our knowledge, this is the first study to evaluate the degree of exchange rate exposure in environments characterized by high currency volatility versus those with low volatility, all within the context of the conditional ICAPM model.