Impact of Currency Risk on Cost of Equity

This study is dedicated to estimating impact of currency risk on cost of equity for Brazil, Russia, India and South Africa. For each country three models that extend Fama-French Three Factor Model by incorporating currency risk are estimated. Currency risk factors are constructed using information about the ratio of currency gains to sales or the magnitude of covariation between equity returns and exchange rate changes. In the second case appreciation and depreciation of domestic currency against US dollar is considered separately. Results indicate that in Russia firms which report substantial currency losses pay a positive risk premium, while in Brazil, India and South Africa companies with significantly positive or negative currency gains pay a lower required return on equity that firms with almost zero currency gains. A possible explanation is that for investors it is difficult to assess true value of such companies. Currency risk premia based on sensitivity of returns on equity to exchange rate changes are significant in all four countries, but data suggests that exchange rate exposure impacts cost of equity differently in countries studied.