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I am planning to estimate Fama-French model for mutual funds with European equity scope. I am thinking about using the European factors from Kenneth French database, which are computed in USD.

The question I faced is: how does Kenneth French data-set arrive at USD returns for European market? Do they assume hedging?

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/f-f_3developed.html

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The paper you should read to understand how they build that dataset is the following:

At the end of section 2 the authors write:

Finally, like the tests of Fama and French (1998), Griffin (2002), Hou, Karolyi, and Kho (2011), and others, our tests of international asset pricing models ignore exchange rate risk. This means we implicitly assume either (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 we consider cannot be used to hedge exchange risk. See, e.g., Fama and Farber (1979) and Adler and Dumas (1983), for the theory, and Dumas and Solnik (1995) and Zhang (2006) for empirical tests that allow for exchange risk. Exchange risks are thus a potential problem in our inferences.

I think this answers your question.

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