4
$\begingroup$

First I have to admit that I have never been really good at thinking about the implications of investments in different currencies. I don't know why but it makes my head spin, this is why I am no FX guy... anyway: Bear with me if this is a silly question!

I have the following situation: I want to thoroughly analyse different equity investments in the Eurozone. Fama-French regression is of course part of that. Now all Fama-French factors (there is a whole bunch of them now) are in USD. Another complicating factor is that - while all investments are in Euros - some are heavily investing internationally themselves and are therefore exposed to currency risk too.

My question
How should I conduct this analysis? Should I

  • leave the investments as is and regress the changes of the Euro denominated investments against the respective USD factors,
  • convert the investments into USD and regress against the respective USD factors or even
  • leave the investments as is and regress the changes of the Euro denominated investments against the respective USD factors + add another currency factor (EUR/USD exchange rate changes)?

What is best practice here? What are the implications? How to interpret the results? Sorry again if this is a silly question.

Improve this question
$\endgroup$
1
  • 1
    $\begingroup$ How about option 4: regress the instruments in EUR against EUR factors and add a currency factor? $\endgroup$
    – assylias
    Mar 30 '16 at 11:36
2
$\begingroup$

It depends on the assumptions you are willing to make.

If you either assume:

  • (i) Complete purchasing power parity (relative prices of goods are the same everywhere and an exchange rate is just the ratio of the nominal prices of any good in two countries) or
  • (ii) the assets you consider cannot be used to hedge exchange risk

then you are fine by using your the solution outlined in your method 2.

  • If you don' want to assume neither of those, then you need empirical tests that allow for exchange rate risk. Look into Fama and Farber (1979) or Zhang (2006).

One caveat though. The Fama-French factors (built on US porfolios) are not the correct factors to analyze Europe returns. Either you build the same factors for Europe, or if the firms you are considering are international you should build world factors (look into Asness, Moskowitz and Pendersen 2013).

Improve this answer
$\endgroup$
4
  • $\begingroup$ Thank you, there are world factors and factors for the European market too - but also in USD! see here: mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/… and here: mba.tuck.dartmouth.edu/pages/faculty/ken.french/… $\endgroup$
    – vonjd
    Mar 30 '16 at 9:47
  • $\begingroup$ Fair enough. Just go ahead and use those. $\endgroup$
    – phdstudent
    Mar 30 '16 at 10:31
  • $\begingroup$ So you are saying that when using the above global or European factors it is best practice to convert the investments into USD and regress against the respective USD factors? $\endgroup$
    – vonjd
    Mar 30 '16 at 11:14
  • 1
    $\begingroup$ You need to double check whether the European/World factors were converted to USD (in which case the returns on the factors include exchange rate risk). If they were then you also need to to convert to USD. If they are in Euros, then do not make the conversion. $\endgroup$
    – phdstudent
    Mar 30 '16 at 11:48
2
$\begingroup$

This is a much discussesd topic in the litrature, I recommend you to read FF2012: "Size, value, and momentum in international stock returns". Best practice is to create Europe, country or even sector specific factors.

Improve this answer
$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.