Hans Dewachter () (K.U.Leuven and Erasmus University of Rotterdam) Kristien Smedts () (K.U.Leuven, C.E.S., International Economics) Konstantijn Maes () (K.U.Leuven, C.E.S., International Economics)
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Absence of arbitrage conditions impose important restrictions on the dynamics of bond and exchange rate returns. It can be shown that the exchange rate serves to convert prices of international undiversifiable risks from one currency to another. Put differently, arbitrage ensures that risk carries the same price in any two countries when evaluated from a particular viewpoint. As a consequence of this, expected returns should be equal after being converted to a common currency. We develop, estimate and test a linear 3-country asset pricing model for exchange risk hedged bond returns. Using US, UK, and German bond portfolio return data we find favorable evidence for the exchange rate being an unconditional converter of prices of risk across countries. Few other papers verify this important arbitrage pricing corollary.
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Paper provided by Katholieke Universiteit Leuven, Centrum voor Economische Studiën, International Economics in its series International Economics Working Papers Series with number
wpie003.
Find related papers by JEL classification: F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements G12 - Financial Economics - - General Financial Markets - - - Asset Pricing G15 - Financial Economics - - General Financial Markets - - - International Financial Markets