The Exchange-Rate Risk Exposure of Asset Returns

Real exchange-rate changes affect bonds differently from stocks. Bonds, having relatively fixed income streams, reflect only an interest-rate effect; stocks reflect a conjunction of interest-rate and cash-flow effects. If exchange rate changes contain information about future interest rates and cash flows over more than one period, then using short horizons may not fully capture exchange exposure, which may explain why prior empirical studies have failed to find an association between stock returns and exchange rates. Using long-horizon returns and long-horizon exchange-rate changes as the authors do provides a clearer picture of exchange exposure.