Empirical properties of currency risk in country index portfolios

We test the first- and second-order effects of exchange rates on World Equity Benchmark Series (WEBS). WEBS are a relatively recent asset class traded in the U.S., which tracks international equities corresponding to the Morgan Stanley Capital International (MSCI) indices closely. We also test the asymmetric effect of currency movement on WEBS using a variant of the GARCH-M methodology. This aspect has not been documented in the finance literature in the context of international equities. With the help of Sign and Size Bias Tests, we find that past exchange rate changes as well as its volatility has a significant bearing on WEBS return. However, most WEBS returns do not carry a significant risk premium for its own volatility. One plausible explanation is that WEBS volatility mostly incorporates the diversifiable risk for the U.S. investors. Our empirical results provide evidence as to where the phenomena, such as momentum, persistence, and reversal are present in this asset class. (C) 2006 Board of Trustees of the University of Illinois. All rights reserved.