Exchange risk and universal returns: A test of international arbitrage pricing theory

According to the international arbitrage pricing theory (IAPT) posited by Solnik (1983), currency movements affect assets' factor loadings and associated risk premiums. Based on a novel universal return decomposition, we propose an empirical model to test this proposition and perform tests using U.S. stock returns in the period 1975–2008. Our results confirm that currency movements significantly affect the market betas of a large proportion of stocks. Further cross-sectional tests indicate that currency movements affecting the market factor are significantly priced in stock returns. Based on these and other findings, we conclude that Solnik's IAPT is supported. An important implication of our findings is that exchange rate risk can broadly affect stock returns through both factor loading and residual factor channels.

► We empirically test Solnik’s (1983) international arbitrage pricing theory (IAPT).
► The IAPT posits that currency movements affect factor loadings and risk premia.
► A novel universal return decomposition isolates the currency component of returns.
► We find that currency movements significantly affect market betas and are priced.
► We conclude that Solnik’s IAPT is supported.