Does Exchange Rate Risk Matter?

Following Adler and Dumas (1983), it is a common practice in the exchange-rate literature to use the contemporaneous exchange-rate change as the relevant risk factor to estimate the risk exposure and risk premium. However, if exchange rate fluctuations are important more because they affect cash flows of firms as Stulz (1984), Smith and Stulz (1985), and Froot, Sharfstein, and Stein (1993) suggest, what matters for asset pricing should be future exchange-rate movements not contemporaneous exchange-rate changes. Furthermore, if as Starks and Wei (2005) suggest exchange-rate fluctuations can push a firm into financial distress, the exchange-rate risk is then a distress factor and should behave like the value factor in the three-factor model. We test these conjectures in this paper, and find evidence suggesting that the premium of the exchange-rate risk is positive, and high BM firms have more positive loadings on this factor. Furthermore, we find that it provides a partially explanation to the ad hoc value factor.