Exchange rate risk in the US stock market

Kolari et al. (2008) show that exchange rate risk measured by contemporaneous exchange rate changes is priced in the US stock market. However, by construction, their exchange rate risk factor has a strong correlation with the size factor, and their exchange rate sensitivity portfolios have a strong factor structure. To test whether their results are spurious, we carry out two sets of tests. The first set is motivated by Lewellen et al. (2010), where the second set is motivated by the voluminous literature which suggests that stock returns are heavy-tailed (e.g. Rachev and Mitnik, 2000). Different from Kolari et al. (2008), we find that exchange rate risk measured by contemporaneous exchange rate changes is not priced in the US stock market if we use industry portfolios which do not have a strong factor structure as the testing assets or if we use more robust methods to estimate firm-specific exchange rate sensitivity. Our findings therefore suggest that researchers take a new perspective on exchange rate risk.