The Role of Currency Risk in Industry Cost of Capital

Abstract

In this paper we test the hypotheses that previous studies fail to find a significant role for currency risk in industry returns because of methodological shortcomings or because of hedging. Using a Fama-French three-factor model augmented with an exchange rate factor in which both the factor exposures and risk premiums are time varying, we find that 35 of 36 U.S. industries are significantly exposed to a broad currency index (containing the currencies of developed and developing economies). In sharp contrast, only 14 industries display significant time-invariant exchange rate exposure using ordinary least squares. More important, the sample means of the time-varying exposures are economically large, with 27 (75%) being greater than 0.10. This resolves the puzzle that previous research finds significant exposure at the aggregate stock market level, but fail to identify the firm or industry level as the source of this aggregate exposure. In addition, currency risk premium is an economically large component of the cost of equity, with 21 industries having a mean currency premium of over 100 basis points per year. Compared to an average cost of equity of 15% per year, the annualized (absolute) currency risk premium is 2.10% for the average industry and is substantially more for some industries. Moreover, 31 of the 36 industries have a mean absolute currency risk premium that is at least one-tenth of the industry's total risk premium. Contrary to the above, an index of the currencies of the developed countries substantially understates the economic importance of currency risk premium. Overall, we find strong support for the methodological, but not the hedging, hypothesis.