The Relationship between the Foreign Exchange Risk Premium and Risk Factors of the Integrated International Equity Markets

This paper tests the effect of equity market risk factors on the foreign exchange risk premium with a more systematical approach from a theoretical viewpoint and eventually aims to reveal the existence and determinants of the foreign exchange risk premium. In order to overcome the limitations of former studies, this paper firstly tests the integration of two countries’ equity markets. Then, for those two countries’ equity markets verified as integrated, this study examines the relationship between the common equity risk factors abstracted from the integrated markets and the foreign exchange risk premium using multiple regression analysis. The testing results show that IAPM(International Arbitrage Pricing Model) is valid for 39 among 45 equity market pairings, and 16 out of the 39 pairings are verified as integrated. Also, the relationships between the foreign exchange risk premium and the common equity risk factors abstracted from the integrated equity markets are shown to be statistically significant for all 16 pairs of equity markets verified as integrated. Since this study supports the argument that the risk factors of the integrated international equity markets can be the determinants of the foreign exchange risk premium, market participants in need of forecasting future foreign exchange rates must carefully observe not only the bond markets but the international capital flows in the overall equity markets.