DIVERSIFIABILITY OF EXCHANGE RISK

Discussions of the determinants of the spot or forward exchange rate frequently argue that holders of foreign assets that are subject to exchange risk must be compensated by a risk premium. This paper shows that much of exchange risk is diversifiable. If there are no outside assets and the value of the currency is uncorrelated with the value of other forms of wealth, then all exchange risk is diversifiable; there is no risk premium. More generally, there is a risk premium, but it need not be related to foreign indebtedness or to the variability of the exchange rate as commonly presumed. © 1979.