Academic journal article Journal of Global Business and Technology

The Exchange Rate Risk in the Johannesburg Stock Market: An Application of the Arbitrage Pricing Model

Academic journal article Journal of Global Business and Technology

The Exchange Rate Risk in the Johannesburg Stock Market: An Application of the Arbitrage Pricing Model

Article excerpt

ABSTRACT

The volatility of exchange rates has caused much concern among policy makers in government, the business community, financial institutions and financial markets as it contributes to international risks. Investors are also concerned about the impact of the exchange rates' movements on both the cash flow of companies' operations and the discount rate employed to value these cash flows. This paper inspects the pricing of exchange rate risk in the South African stock market, using a two-factor arbitrage pricing model. After examining the Johannesburg Stock exchange All Share Index Top40 (ALSI Top40) companies, the conclusion is reached that these companies tend to be negatively exposed to the exchange rate risk. The unconditional premium attached to the foreign exchange rate exposure is found to be 2.2% per month and is both economically and statistically significant. The exchange rate does not appear to be diversifiable (systematic risk) and active hedging policies by financial managers can affect the cost of capital. Investors should, therefore, earn a premium by being exposed to the foreign exchange rate risk.

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

One of the concerns for investors is the issue of foreign exchange rate risk exposure, that is, exchange rate movements that affect both the cash flow of a firm's operations and the discount rate employed to value these cash flows. These foreign exchange rate risks are a result of currencies' movements which have increased because many countries have shifted their policies toward independently floating exchange rates. The contribution of foreign exchange risks to international risks needs to be identified in order to decide whether these foreign exchange risks can be diversified. If foreign exchange rate risks cannot be diversified, investors would be willing to pay a premium on the assets that are exposed to currency risks. The foreign exchange rate is, therefore, recognised as one of the most important dimensions of foreign investment and international asset pricing. Thus, asset pricing can be used to incorporate the exchange rate risk premium that compensates for the exchange rate risk exposure.

Given the increasing openness of the South African economy, South African firms can be considerably affected by the fluctuation in the value of the rand (South African currency) compared to other currencies. The end of sanctions in 1994 and the abolition of the dual exchange rate in March 1995, have led to the increased foreign investment portfolio in the Johannesburg Stock Exchange (JSE) due to the increase in the trade between domestic and foreign companies (Jefferis & Okeahalam, 2000). Hence, the exposure of the South African stock market to exchange risk has increased because of the increase in the foreign capital flow and internationalisation of some of South African firms. Barr et al. (2007) indicate that the exchange rate volatility has pulled the JSE All Share Index and Top40 in different directions (both negative and positive) because the exchange rate has a more immediate impact on certain stocks and delayed or non-immediate impact on other stocks. If this aggregate effect of the exchange rate volatility on the JSE is not balanced and cannot be eliminated through diversification, it then becomes a systematic risk. The empirical evidence has produced mixed results on these issues and most studies have relied on U.S., European and Australian data. Since the South African economy may differ from the economies of these countries and the exchange rate exposure of the JSE companies has increased from 1994, there is a need to identify whether the exchange rate risk is priced in the Johannesburg Stock Exchange or not. The objective of this paper is to make use of the Asset Pricing Theory (APT) to investigate the foreign currency exposure of the JSE Top40 companies and the pricing of exchange rate risk in the South African stock market together with the level of risk premium attached to this foreign currency exposure. …

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