Dollar beta and stock returns

Abstract

The financial channel of exchange rates operates through changes in risk-taking by investors and is reflected in the response of financial conditions to exchange rate movements. We show that stock returns also reflect the financial channel of exchange rates, with higher local currency stock returns associated with a weaker dollar. The broad dollar index emerges as a global factor, consistent with the financial channel operating through swings in risk-taking by global investors. We introduce the ‘dollar beta’ as the sensitivity of stock returns to swings in the broad dollar index and show that emerging market stock indices that have a higher dollar beta tend to have higher average returns, implying that the dollar beta is a cross-section risk factor that is priced.