Foreign Exchange Exposure and the Term-Structure of Industry Cost of Equity

Abstract

Using a single-factor Global CAPM (GCAPM) and a two-factor International CAPM (InCAPM), we study the effect of foreign exchange (FX) exposure on the term structure of industry cost of equity of 39 U.S. industries. Following Ang and Liu (2004), we estimate the term structure of industry expected returns at the end of 2010 and find that: 1) Capturing FX exposure in the asset-pricing model changes the position and shape of the spot discount curves; 2) The average industry FX risk premium is around 3% for cash flows with short-term maturities (around 24% of the total industry cost of equity); 3) For most industries the FX risk premium declines with increasing cash flow maturities; 4) The pricing error from ignoring the term structure is substantially larger than the pricing error resulting from the omission of the FX risk component.