THE EFFECT OF EXCHANGE RATE RISK ON THE CONDITIONAL RELATIONSHIP BETWEEN BETA RISK AND RETURN IN INTERNATIONAL EQUITY MARKETS

The paper examines the effect of exchange rate risk on the conditional relationship between beta risk and return in international equity markets from January 1978 through September 2004. We use an extension of the model introduced by Pettengill, Sundaran, and Mathur (PSM Model, 1995) and adapted by several authors afterwards. The empirical results show evidence in international markets that are compatible with the PSM model and some international studies addressing returns that are unhedged against exchange rate risk. However, when this risk is controlled and hedged with forward contracts, the conditional relationship between beta risk and return appears asymmetric and presents a lower beta risk premium than the one takes place under unhedged returns in up-market months. A main business implication of the findings follows: international equity market administrators and portfolio managers can defend themselves against exchange risk by using forward contracts, particularly in world stock market conditions similar to those discussed throughout the paper.