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Do Foreign Investors Price Foreign Exchange Risk Differently?

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  • Taek Ho Kwon
  • Sung C. Bae
  • Jay M. Chung

Abstract

We test whether foreign investors price foreign exchange risk differently from local investors. Drawing from the closed-end country fund literature, we argue that both differential access to information by foreign versus local investors and different sources of exchange risk that investors face (economic or translation exposure) will lead to different pricing of the exchange risk associated with American Depositary Receipt (ADR) investments. We apply a two-step method to country portfolios of ADRs of Australia, France, Japan, and the United Kingdom traded on the New York Stock Exchange. Our results show that foreign investors generally price exchange risk differently from local investors, and that the source and magnitude of differences in exchange risk pricing vary significantly across countries. Although significant differences in pricing exchange risk between foreign and local investors are observed for Australia, France, and Japan, no such pricing difference is noticed for the United Kingdom. Furthermore, the pricing differences observed for Australian and French ADRs are mainly attributed to the exchange risk of underlying share returns (economic exposure), whereas the pricing differences for Japanese ADRs are mainly attributed to the exchange risk associated with currency translation (translation exposure). We offer some explanations for our findings. 2005 The Southern Finance Association and the Southwestern Finance Association.

Suggested Citation

  • Taek Ho Kwon & Sung C. Bae & Jay M. Chung, 2005. "Do Foreign Investors Price Foreign Exchange Risk Differently?," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 28(4), pages 555-573.
  • Handle: RePEc:bla:jfnres:v:28:y:2005:i:4:p:555-573
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    1. repec:eee:reveco:v:53:y:2018:i:c:p:133-150 is not listed on IDEAS
    2. Bae, Sung C. & Li, Mingsheng & Shi, Jing, 2009. "Does the law of one price hold better under a flexible exchange rate system?," Journal of Multinational Financial Management, Elsevier, vol. 19(4), pages 306-322, October.

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