Abstract
We study whether exchange rate risk is priced in asset returns and how it is related to risk transmission channels using Chinese data. We find that foreign exchange rate risk is not priced in asset returns under the pegged exchange rate system. However, foreign exchange risk measured with U.S. dollar denominated exchange rate is priced under the managed floating exchange rate regime following the 2005 reform. We further examine the transmission mechanisms through which the exchange rate risk could impact asset returns. Evidence from market response to announcement of foreign exchange rate as well as asset pricing tests for stocks sorted by sensitivity to transmission channels suggest that ‘international trade’ and ‘credit expansion’ are particularly important channels in transmitting the exchange rate risk. The effects of exchange rate movements and transmission channels on asset returns seem to be permanent. Overall our results imply that effective policies dealing with exchange rate risk and financial stability should address the important transmission mechanisms.