Do Exchange Rates Convert Prices of Risk Across Countries?

27 Pages Posted: 4 Nov 2001

See all articles by Hans Dewachter

Hans Dewachter

Catholic University of Leuven (KUL) - Department of Economics; Erasmus Research Institute of Management (ERIM)

Stan Maes

European Commission - DG Internal market and financial services; European Commission - DG Competition; KU Leuven - Department of Economics

Kristien Smedts

KU Leuven - Faculty of Business and Economics (FEB)

Date Written: September 2001

Abstract

Absence of arbitrage conditions impose important restrictions on the dynamics of bond and exchange rate returns. It can be shown that the exchange rate serves to convert prices of international undiversifiable risks from one currency to another. Put differently, arbitrage ensures that risk carries the same price in any two countries when evaluated from a particular viewpoint. As a consequence of this, expected returns should be equal after being converted to a common currency. We develop, estimate and test a linear 3-country asset pricing model for exchange risk hedged bond returns. Using US, UK, and German bond portfolio return data we find favorable evidence for the exchange rate being an unconditional converter of prices of risk across countries. Few other papers verify this important arbitrage pricing corollary.

Keywords: multi-country asset pricing model, exchange risk, price of risk conversion

JEL Classification: F21, G12, G15

Suggested Citation

Dewachter, Hans and Maes, Konstantijn and Smedts, Kristien, Do Exchange Rates Convert Prices of Risk Across Countries? (September 2001). Available at SSRN: https://ssrn.com/abstract=289333 or http://dx.doi.org/10.2139/ssrn.289333

Hans Dewachter (Contact Author)

Catholic University of Leuven (KUL) - Department of Economics ( email )

Center for Economic Studies
Naamsestraat 69
Leuven, B-3000
Belgium
+0032 16 326859 (Phone)
+0032 16 326796 (Fax)

Erasmus Research Institute of Management (ERIM)

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Konstantijn Maes

European Commission - DG Internal market and financial services ( email )

Rue de la Loi 200
Brussels, B-1049
Belgium

European Commission - DG Competition ( email )

Place Madou, Madouplein 1
Saint-Josse-ten-Noode/Sint-Joost-ten-Noode
Brussels, B-1049
Belgium

KU Leuven - Department of Economics ( email )

Naamsestraat 69
2nd Floor
B-3000 Leuven
Belgium

HOME PAGE: http://www.econ.kuleuven.ac.be/ew/academic/intecon

Kristien Smedts

KU Leuven - Faculty of Business and Economics (FEB) ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

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