Exchange Rates and the Conversion of Currency-Specific Risk Premia

How do the risk factors that drive asset prices influence exchange rates? Are the parameters of asset price processes relevant for specifying exchange rate processes? Since most international asset pricing models focus on the analysis of asset returns given exchange rate processes, there is only little work on these questions. This paper uses an international stochastic discount factor (SDF) framework to analyze the interplay between asset prices and exchange rates. So far, this approach has only been implemented in international term structure models. We find that exchange rates serve to convert currency-specific discount factors and currency-specific prices of risk - a result linked to the international arbitrage pricing theory (IAPT). Our empirical investigation presents evidence for the conversion of currency-specific risk premia by exchange rates