Exchange Rate and Foreign Inflation Risk Premiums in Global Equity Returns

Abstract

We test for the pricing of exchange rate and foreign inflation risk in equities. Our tests are motivated by the empirical implications of the models of Solnik (1974b) as revised by Sercu (1980), Grauer, Litzenberger, and Stehle (1976), and Adler and Dumas (1983). Both exchange rate and foreign inflation risk factors can explain part of the within-country cross-sectional variation in returns. Our results have important implications for hedging exchange rate risk. They also demonstrate that home bias, at least in US equity portfolios, cannot be the result of US investors' efforts to hedge their domestic inflation.

JEL Classification: G11, G12, G15