Dollar beta and stock returns

Summary

Focus

Operating through changes in market participants' risk capacity, the financial channel of exchange rates demonstrates how domestic financial conditions respond to exchange rate movements. We investigate whether stock market returns in emerging market economies (EMEs) reflect the financial channel of exchange rates. If so, we also consider if the broad dollar index has attributes of a cross-sectional asset pricing factor in EME stock markets, just as the broad dollar index serves as an indicator of the financial channel of exchange rate in other contexts.

Contribution

The study makes three contributions in laying out the impact of the financial channel of exchange rates on stock market returns. First, we introduce "the dollar return multiplier" as the ratio of the dollar-denominated stock returns to the local currency stock returns and show that the dollar return multiplier is typically larger than one. Second, we show that the broad dollar index serves as a global factor in determining stock returns, with a stronger dollar being associated with lower stock returns. Third, we introduce the notion of the "dollar beta" as the sensitivity of stock returns to swings in the broad dollar index. The dollar beta is a risk factor in the sense that investors who bear dollar risk are compensated with higher expected stock returns.

Findings

Our finding that the dollar return multiplier is larger than one in all EMEs implies that the dollar-denominated returns tend to be amplified versions of the local currency returns. When both the broad dollar index and the bilateral dollar exchange rate enter as explanatory variables in regressions for stock market returns in EMEs, the broad dollar index remains the more important determinant of stock returns. Finally, our finding that EME stock indices with a high dollar beta tend to have higher average returns ties in well with the notion that the broad dollar index is a useful indicator of "risk-on" and "risk-off" sentiment in global stock markets.

Abstract

The financial channel of exchange rates operates through changes in risk-taking by investors and is reflected in the response of financial conditions to exchange rate movements. We show that stock returns also reflect the financial channel of exchange rates, with higher local currency stock returns associated with a weaker dollar. The broad dollar index emerges as a global factor, consistent with the financial channel operating through swings in risk-taking by global investors. We introduce the "dollar beta" as the sensitivity of stock returns to swings in the broad dollar index, and show that emerging market stock indices that have a higher dollar beta tend to have higher average returns, implying that the dollar beta is a cross-section risk factor that is priced.

JEL classification: G12, G15, G23.

Keywords: global liquidity, pricing factor, emerging market, exchange rate.