Foreign Exchange Exposure, Risk and the Japanese Stock Market

Abstract

This paper presents a comprehensive empirical examination of the foreign exposure effect on Japanese corporations and sectors. We provide compelling evidence that, after controlling for marketwide movements, the exposure effect on Japanese corporations' stock returns is both statistically and economically significant. Based on a wide array of about 1200 Japanese firms and a group of 23 different Japanese industries in our sample, we find that Japanese stock returns on average are negatively correlated with contemporaneous exchange rate changes but are virtually uncorrelated with lagged exchange rate fluctuations. The results are robust not only across exporting and non-exporting firms and industries, but also across the sample period, indicating the presence of time variation in exposure effects. An exploratory investigation suggests that time-varying exposures are related to regime-switching exchange rate dynamics, and these effects are more pronounced in industries with high exports. We further show that both the market and currency risks are priced in the Japanese stock market and that their conditional components are time-varying. Overall, our results suggest that Japanese stock investors cannot diversify away the market risk, nor can they diversify away the currency risk.

JEL Classification: F31, G12