Controlled Currency Regime and Pricing of Exchange Rate Risk: Evidence From China
Forthcoming in Journal of Accounting, Auditing & Finance
61 Pages Posted: 26 Dec 2018
Date Written: June 7, 2018
Extant research finds that exchange rate pegs do little to reduce firms’ exposure to exchange rate risk in emerging markets. We study whether exchange rate risk exposures under a pegged/controlled floating currency regime can be priced in asset returns using unique data on exchange rate regime changes in China. As the only currency in the basket of IMF’s Special Drawing Rights that is not fully market driven for its exchange rate formation, the Chinese RMB offers an ideal case to study the pricing of exchange rate risk in pegged and controlled floating regimes. We find a negative stock market reaction to the announcement of changes from a pegged exchange rate to a controlled floating regime, suggesting a negative stock valuation effect of expectation of increased exchange rate exposure to currency appreciation. Under the managed floating exchange rate regime, the volatilities of accounting performance measures are significantly greater for the companies with stronger exposure to foreign exchange rate risk. More importantly, foreign exchange rate risk is priced in equity returns under the controlled floating regime but not under the strictly pegged regime. Furthermore, the pricing is stronger for firms with higher sensitivity to economic channels transmitting the exchange rate risk exposure to risk premiums. Overall, our results suggest that currency hedging for a multinational corporation with foreign exchange exposure is warranted under a controlled floating currency regime.
Keywords: Exchange Rate Risk, Asset Returns, Equity Risk Premium, Foreign Exchange Rate Risk Hedging, Chinese Currency Risk
JEL Classification: F30, F31, G12
Suggested Citation: Suggested Citation