Foreign Exchange Risk and Risk Exposure in the Japanese Stock Market

Purpose – Whether stock returns are linked to exchange rate changes and whether foreign exchange risk is priced in a domestic context are less conclusive and thus still subject to a great debate. This paper attempts to provide new empirical evidence on these two inter-related issues, which are critical to investors and corporate risk management. Design/methodology/approach – This paper applies two different econometric approaches: Nonlinear Seemingly Unrelated Regression (NLSUR) via Hansen's (1982) Generalized Method of Moment (GMM) and multivariate GARCH in mean (MGARCH-M) to examine the exchange rate exposure and its pricing.Findings – Using industry data for Japan, similar to previous studies, foreign exchange risk is not priced based on the test of an unconditional two-factor asset pricing model. However, strong evidence of time-varying foreign exchange risk premium and significant exchange rate betas are obtained based on the tests of conditional asset pricing models using multivariate GARCH in mean (MGARCH-M) approach where both conditional first and second moments of industry returns and risk factors are estimated simultaneously.Research limitations/implications – The strong empirical evidence found in this study implies that corporate currency hedging not only results in more stable cash flows for a firm, but also reduces its cost of capital, and hence is justifiable.Originality/value – This paper conducts an in-depth investigation regarding the exchange rate exposure and its pricing by utilizing two different econometric approaches: Nonlinear Seemingly Unrelated Regression (NLSUR) via Hansen's (1982) Generalized Method of Moment (GMM) and multivariate GARCH in mean (MGARCH-M). In doing so, a more reliable conclusion about the exchange rate exposure and its pricing can be drawn