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) [Solnik, B., 1974b. The international pricing of risk: an empirical investigation of the world capital market structure. Journal of Finance 365–377] as revised by Sercu (1980) [Sercu, P., 1980. A generalization of the international asset pricing model. Revue de l'Association Française de Finance 1, 91–135], Grauer et al. (1976) [Grauer, F., Litzenberger, R., Stehle, R., 1976. Sharing rules and equilibrium in an international capital market under uncertainty. Journal of Financial Economics 3, 233–256], and Adler and Dumas (1983) [Adler, M., Dumas, B., 1983. International portfolio choice and corporation finance: a synthesis. Journal of Finance 38, 925–984]. 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.
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