Foreign exchange risk and the cross-section of stock returns by Kolari, Moorman, & Sorescu (2008).

Foreign exchange risk is the risk that a businesss financial performance or position will be affected by fluctuations in the exchange rates between currencies (CPA Australia, 2009). Thus, the volatility of exchange rates and its associated risks have become more important component of international financial management after the incident breakdown of the Bretton Woods fixed-parity system in the early 1970s. Muller and Verschoor (2006) stated that standard economic analysis implies that exchange rate movements affect both the cash flow of a firms operations and discount rate employed to value a firm. From a theoretical perspective, it is a generally held view that exchange rate fluctuations are an important source of macroeconomic uncertainty, thus they should have a significant impact on firm value, regardless of whether the firm is domestically or internationally oriented (Shapiro, 1975). On the other hand, Muller and Verschoor (2006) claims that studies have so far documented weak contemporaneous relationships between exchange rates and US stock returns, international evidence focusing on more open economies yield more significant currency risk exposure estimates. A possible rationalization for the difficulties in documenting a measurable impact of foreign exchange risk on stock market values is that firms are aware of their currency exposures and are eliminating foreign currency risk by hedging (Bartov & Bodnar, 1994).

According to authors of this journal who are Kolari, Moorman and Sorescu (2008), they have been examined the relation between the cross-section of US stock returns and foreign rates during the period from 1973 to 2002. Thus the results have showed that foreign exchange risk is priced in the cross-section of US stock returns, and the market price of this risk is negative. Kolari et al. (2008) found that stock with extreme absolute foreign exchange-sensitivy in both positive and negative were appeared to have lower expected returns than others. They implies that these forex-sensitive stocks tend to be small firms in financial distress, the type of firms that would normally command higher than average expected return based on the finding of Fama and French (1992). Thus, these firms indicates that they have such low cost of equity is remarkable (Kolari et al., 2008).

However, the results of the authors founded were different from what might be expected under a standard asset-pricing paradigm. In generally, most of the asset pricing theories posit a linear relation between expected returns and risk factors, including foreign exchange factors. Thus, the finding of a negative foreign exchange risk premium by Kolari et al. (2008) is not directly comparable with the predictions of any known theoretical foreign exchange model. Compared to Adler and Dumas (1983) research, they demonstrated that the market price of foreign exchange risk may be negative when investors are sufficiently risk-averse, the relation between expected returns and factor loadings remains linear. Thus, the implications of their negative price of risk are different from Kolari et al. (2008). Furthermore, in their model, foreign investors are willing to accept a lower rate of return on US stocks whose returns are inversely correlated with the strength of the dollar as an exporter,

to compensate for the lower returns expressed in local currency. But these same investors would require a higher expected return at the other end of the sensitivity spectrum, that is, for US stocks whose returns are positively correlated with the strength of the dollar as an importer position. In contrast, Kolari et al. (2008) found that both importers and exporters have lower expected returns than others. However, the difference between the inverse U-shape relations that documented in authors study and the linear relation predicted by standard asset-pricing model is quite puzzling. Kolari et al. (2008) stated that one possible explanation is based on theoretical work by Johnson (2004). Johnson (2004) showed that total asset volatility is inversely related to expected stock returns, and the strength of this relation increases with leverage. Thus, this idea is motivated by looking at equity as a call option on the firms assets. In the Black and Scholes (1973) model, an increase in underlying volatility results in a decrease of call options expected rate of return, and this effect is stronger for options that are near the money, where the increase in the option price is larger than the corresponding increase in its expected payoffs (Kolari et al., 2008). Thus, extending these arguments to equity and firm values instead of calls and stocks, Johson (2004) infers that, for leveraged firms, expected equity returns are decreasing in asset volatility.

Besides that, Kolari et al. (2008) found that, firm in portfolios 1 and 25 have low expected returns. Thus, they implies that why firms in portfolio 1 and 25 may have low expected return is because of their abnormally high cash flows volatility resulting from foreign exchange exposure induces an option-like premium in their equity prices which supported by Johnson

(2004) option-theoretic model where this high cash flows volatility translates into higher equity prices and lower expected return. As a conclusion, Kolari et al. (2008) showed that foreign exchange risk is priced in the cross-section of US stock returns during the period from 1973-2002. They demonstrated that firms with extreme absolute sensitivity to foreign exchange have lower required rates of return than other stocks, where expected returns are lower for both importers and exporters with extreme foreign exchange-sensitivity. Thus, Kolari et al. (2008) suggested that the relation between expected returns and foreign exchange exposure is non-linear and inverse U-shaped, in contrast with predictions of standard asset-pricing models that generally posit a linear relation between expected returns and risk factor loadings. Nevertheless, within the framework of this non-linear relation, they found that the market price of foreign exchange risk is negative. Besides that, an option-theoretic model of Johnson (2004) is a possible explanation for non-linear relation, which expected stock returns are lower for firms with high idiosyncratic cash flows volatility. Thus, Kolari et al. suggested that firms with high foreign exchange-sensitivities are also likely to have high cash flow volatilities.