The pricing of foreign exchange risk in the Australian equities market

Abstract

The issue of whether foreign exchange risk is priced in financial markets is important in the context of international investment and diversification. Primarily using daily data, we implement a two-factor asset pricing model (incorporating a market factor and an exchange rate factor) in an attempt to provide some insight into the pricing of foreign exchange risk in the Australian equities market for the period 1988–1998. Initially testing a basic version of the model, we find that exchange rate risk is priced in the Australian equities market for the full sample period. Further, our analysis of four major subperiods indicates that the pricing occurs in periods of economic decline and a secularly weak Australian dollar (namely, 1990–1993 and 1997–1998). We extend our investigation by testing a zero-beta version, as well as an orthogonalized version, of the same model. The results of both analyses support our initial findings.