Foreign Exchange Risk and the Term-Structure of Industry Costs of Equity (Digest Summary)

The authors provide a model to examine the impact of foreign exchange (FX) risk exposure on the cost-of-equity term structure used in equity valuation. The model allows them to isolate an FX risk premium for a cross-section of US industry groups. Substantial differences in the FX risk premium among industry groups are identified, and the authors relate the differences to economically meaningful characteristics. The average FX risk premium in US equity is found to be 2.29% for short-term maturities in the term structure.

FX exposure and the associated risk have long been a consideration when valuing equity investments. The authors offer a tractable model that can be used to identify the FX risk premium that is incorporated in equity prices. They apply their model to US equity and show that differences in FX risk premiums among industries can be directly related to economically meaningful characteristics, such as percentage of foreign sales.

Examining the term structure of equity, the FX risk premium is found to rapidly decline with increasing cash flow maturities, starting at 2.29% for the short term, falling to 0% at the 10-year point, and becoming negative for longer-term cash flows. The authors suggest that given this term-structure characteristic, practitioners who ignore the FX component when using a cost-of-equity approach to valuation could be subject to significant valuation errors.

Practitioners who already account for FX risk exposure in their valuation process are offered a new way of validating their existing approaches.

The authors build on the methodology of Ang and Liu (Journal of Finance 2004) to model the cost-of-equity term structure and extend the methodology to include a consideration for FX risk exposure. The challenge with creating a term structure of risky cash flows is that there is no equivalent to the zero-coupon bond for equity investments. The authors define a theoretical zero-coupon equity to use in constructing the term structure.

Both the global CAPM (GCAPM) and two-factor international CAPM (ICAPM) are used. The GCAPM is used to model expected industry returns excluding FX risk, and the ICAPM is used to model expected industry returns including the FX risk. To collapse all FX risk exposures into a single factor, the authors follow a technique used by Ferson and Harvey (Review of Financial Studies 1993).

Both models are used in conjunction with the zero-coupon-equity term structure to plot the term structure of industry expected returns for each model. The difference between the two curves is attributed to the FX risk premium.

The technique is then applied to US equity data from 1978 to 2011, and the authors are able to construct industry-level cost-of-equity term structures and estimate the FX risk premium associated with each industry. They examine the characteristics of the individual industry groups and are able to relate differences among industry FX risk premiums to economically meaningful characteristics, such as average size of companies.

FX exposure is a source of volatility that has surprised many companies and investors, such as the volatility observed in the Swiss franc in early 2015. So, it comes as no revelation that it is an important factor to consider when evaluating an investment; moreover, there is a significant risk premium associated with it. The authors have constructed a practical model that can be used by practitioners and academics alike. As the authors suggest, further exploration of the time-varying characteristics of the FX risk premium would be extremely interesting, especially if a similar decomposition of fixed-income yield curves can be achieved.