Pricing of foreign exchange rate and interest rate risks using short to long horizon returns

Nathan Lael Joseph, Chen Su, Winifred Huang and Baoying Lai

The European Journal of Finance, 2021, vol. 27, issue 17, 1684-1713

Abstract: In this paper, we test whether foreign exchange (FX) rate and interest rate (IR) risks are priced at short to long return horizons. We also test whether the associated risk premia relate to certain stock characteristics. Our new evidence indicates that risk premia increase with the length of the return horizon and that the risk premium signs depend on the sign of the corresponding exposure beta. Thus, for our longest return horizon of 950 days, positive (negative) FX rate premia increase in absolute value to 2.642% (–2.050%), whereas positive (negative) IR premia increase to 1.039% (–1.151%). Zero exposure betas have zero risk premia. We find that, depending on the level of profitability, Size, book-to-market-ratio (B/M) and sales-to-stock price ratio (S/P) explain most of the variation in exposure betas and risk premia. Our results imply that investors view exposure betas and risk premia as important factors affecting portfolio returns.

Date: 2021
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DOI: 10.1080/1351847X.2021.1927127

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