Can Foreign Exchange Risk Hedge Other Sources of Risk? A Multifactor Analysis

Abstract

An investor who assumes foreign exchange risk by making an unhedged foreign investment can use it to hedge other sources of risk. Comparisons of the relations between the hedged and unhedged returns for 19 developed country stock indexes and risk factors faced by a U.S. investor show significant differences for the default spread, industrial production, and term spread. This can be the case even when the U.S. dollar is appreciating against the foreign currencies. The joint moments between the foreign exchange fluctuations, underlying stock returns, and the risk factors are also important.

Keywords: International Asset Pricing, Exchange Rates,Foreign Exchange Risk

JEL Classification: F31, G12