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Foreign Exchange Risk and the Term-Structure of Industry Costs of Equity

This paper makes two contributions to the literature. First, we build on the methodology of Ang and Liu (2004) to model the cost of capital term-structure for firms subject to foreign exchange (FX) risk. We emphasize the role of time-varying parameters such as FX risk and factor loadings. Second, we estimate the term-structure for 39 U.S. industries. We find that: 1) FX exposure changes the position and shape of the term-structures; 2) The average FX risk premium is 2.29% for cash flows with short-term maturity, but declines as maturity increases; 3) The pricing error from ignoring the term-structure is smaller than the error resulting from the omission of the FX risk component.