Do Exchange Rates Convert Prices of Risk Across Countries?
27 Pages Posted: 4 Nov 2001
Date Written: September 2001
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: Suggested Citation