The Role of Exchange Rates in the Intertemporal Risk-Return Relation in International Economies

This paper investigates the role of currency denomination in the the intertemporal risk-return relation among G7 countries. Similar to the findings of previous studies, our estimation also shows that the financial markets of the G7 countries are integrated. We obtain significant pricing coefficient estimates on the global index, but insignificant estimates on country-specific risks. Different from the literature, however, we find that the intertemporal risk-return relation differ significantly under different currency denominations. The slope coefficient estimate is the largest at around seven when the returns are denominated in Japanese yen, smallest at around three to four when the returns are denominated in pound or euro and its predecessors. The slope estimates are in the middle at about five to six when the returns are denominated in the U.S. or Canadian dollar. The estimates stay in the same range and the rankings remain unchanged when we consider different specifications for the conditional covariance estimations and when we replace country-specific portfolios with industry-specific forms in estimating the intertemporal relation.