The Share of Systematic Risk in Foreign Exchange and Stock Markets

Abstract

Is there a common systematic risk between the foreign exchange market and the stock market? To answer this question, a two-country affine model of exchange rates is proposed to obtain a so-called Forex-specific factor. We show that this factor is an important driver of the stock market risk premium. Not only it contributes a sizable portion of exchange rate volatility, but also outperforms the commonly-used financial and macroeconomic variables in terms of predicting stock excess returns. The predictive power is robust with respect to forecasting horizons, and to different industry and characteristic portfolios. In addition, the cross-sectional study shows that the Forex-specific factor has substantial explanatory power for cross-section return differences of industry portfolios, the performance is better than Fama-French three factor model and is comparable with that of the up-to-date five factor model.