Persistent exchange-rate movements and stock returns

• We hypothesize that persistent exchange-rate movements are a distress risk.
• We use the tracking portfolio approach to construct the exchange-rate factor.
• We find empirical evidence that supports our hypothesis.
• Our evidence provides an alternative explanation for the exposure puzzle.
• We suggest that exchange-rate risk is a state variable underlying SMB and HML.

We hypothesize that persistent exchange-rate movements are a distress risk and a state variable in the Merton (1973) sense. To test our hypothesis, we use the tracking portfolio approach of Lamont (2001) to capture news about future persistent exchange-rate movements. We find empirical evidence that supports our hypothesis, which has important implications for both international finance and empirical asset pricing. For international finance, our evidence provides an alternative explanation for the exposure puzzle and suggests researchers focus on persistent, instead of contemporaneous, exchange-rate movements. For empirical asset pricing, our findings imply a fresh and plausible perspective of exchange-rate risk, a state variable underlying the Fama–French factors.