Foreign exchange risk and the cross-section of stock returns

We examine the relation between the cross-section of US stock returns and foreign exchange rates during the period from 1973 to 2002. We find that stocks most sensitive to foreign exchange risk (in absolute value) have lower returns than others. This implies a non-linear, negative premium for foreign exchange risk. Sensitivity to foreign exchange generates a cross-sectional spread in stock returns unexplained by existing asset-pricing models. Consequently, we form a zero-investment factor related to foreign exchange-sensitivity and show that it can reduce mean pricing errors for exchange-sensitive portfolios. One possible explanation for our findings includes Johnson's [2004. Forecast dispersion and the cross-section of expected returns. Journal of Finance, 59, 1957-1978] option-theoretic model in which expected returns are decreasing in idiosyncratic cashflow volatility.