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European Fama-French Factors Ignore Exchange-Rate Risk

Article Quant Q&A · Author: Mariia Kuzn
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Summary

The document asks how the European equity factors in the Kenneth French data library are expressed in US dollars and whether the returns assume currency hedging. The response points to the research paper describing the international factor construction and explains that its asset-pricing tests ignore exchange-rate risk.

The cited approach therefore does not establish that the reported returns are currency-hedged. Instead, the analysis implicitly relies on assumptions such as complete purchasing power parity or assets being unable to hedge exchange risk. The answer highlights currency exposure as a potential limitation when interpreting international factor results. It gives a conceptual explanation tied to the cited paper, but does not detail the dataset’s currency conversion procedure or quantify how including exchange-rate risk would change estimated factor returns or conclusions.

Key ideas

  • The cited international asset-pricing tests ignore exchange-rate risk.
  • Ignoring currency risk implicitly relies on assumptions about purchasing power parity or hedging possibilities.
  • The document does not establish that the European factor returns are currency-hedged.
  • Exchange-rate risk may affect inferences from international factor models.

Tags

EquitiesFactor investingForexStatistics
Full text
# Returns and Factors for European Market Kenneth French Database


# Returns and Factors for European Market Kenneth French Database












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

## Answer by phdstudent (score 2)

https://quant.stackexchange.com/a/38819

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

- Fama-French (2012): Size, value, and momentum in international stock returns

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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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.