CASH FLOWS, CURRENCY RISK, AND THE COST OF CAPITAL

• Author: Ou Hu,Ding Du
• Date: 01 June 2014
• Published date: 01 June 2014
• DOI: http://doi.org/10.1111/jfir.12032

CASH FLOWS, CURRENCY RISK, AND THE COST OF CAPITAL

Ding Du

Northern Arizona University

Ou Hu

Youngstown State University

Abstract

Currency fluctuations can affect firms’cash flows. There is evidence that cash flows are

related to a covariance risk factor in global stock markets. Taken together, these two lines of

research suggest that the underlying link between currency movements and stock returns

may be the cash flow. We test this transmission mechanism with the mimicking portfolio

approach. Empirically, we find that our test assets have significant exposure to the currency

factor‐mimicking portfolio and this factor carries a significant and positive risk premium.

JEL Classification: F31, G12, G15

I. Introduction

We examine whether currency risk affects stock returns through its impact on cash flows.

Our investigation is motivated by the following two lines of research. First, Shapiro

(1974), Dumas (1978), and Levi (1990) suggest that currency fluctuations can affect

firms’cash flows. Second, Hou, Karolyi, and Kho (2011) recently find that cash flows are

related to a covariance risk factor in global stock markets. More specifically, Hou,

Karolyi, and Kho find that their cash‐flow factor‐mimicking portfolio always carries an

economically and statistically significant risk premium even after controlling for variation

in the cash flow characteristic.

Empirically, following the recent literature (e.g., Kolari, Moorman, and

Sorescu 2008), we use the factor‐mimicking portfolio approach of Fama and French

(1992, 1993) to construct the currency risk factor. As we discuss in Section II, this

approach has a number of advantages compared to using exchange rate changes. More

specifically, we construct a zero‐investment portfolio that takes long positions in stocks

whose cash flows are sensitive (in absolute value) to currency movements and short

positions in stocks whose cash flows are insensitive to currency fluctuations. We refer to

this factor as XMI (or sensitive minus insensitive). If currency risk affects stock returns

through its impact on cash flows, we expect that XMI helps explain the cross‐section of

stock returns. That is, we expect that many assets have significant exposure to XMI, and

that XMI carries a significant risk premium.

We thank the editors Scott Hein, Jeff Mercer, and Drew Winters for their valuable suggestions. The insightful

comments of an associate editor and an anonymous referee helped substantially improve the quality of this paper.

The responsibility of any remaining errors is ours.

The Journal of Financial Research Vol. XXXVII, No. 2 Pages 139–158 Summer 2014

139

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RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

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To test our conjecture, we use the time‐series regression approach of Fama and

French (1996) to estimate currency exposure and the cross‐sectional regression

methodology of Fama and MacBeth (1973) to estimate currency risk premium. Our

empirical results can be easily summarized. We find that, indeed, many of our test assets

have significant exposure to XMI, and XMI carries a statistically and economically

significant risk premium. We perform extensive robustness checks in Section III to ensure

that our results are not spurious.

The present article contributes to the literature in two ways. First, in international

finance, the evidence that currency risk helps explain the cross‐section of stock returns is

still limited. The majority of empirical studies find that only low proportions of U.S.

stocks have significant currency exposure and currency risk is not priced (e.g.,

Jorion 1990, 1991; Bartov and Bodnar 1994; Chow, Lee, and Solt 1997; Griffin 2002; Du

and Hu 2012). Bartram, Brown, and Minton (2010) thus argue that firms use (financial)

hedging to greatly reduce currency exposures. One exception is Francis, Hasan, and

Hunter (2008). By using a conditional asset pricing model, Francis, Hasan, and Hunter

find that currency risk affects the cost of capital of U.S. industry portfolios. The present

article strengthens Francis, Hasan, and Hunter by providing new supporting evidence of

currency risk in the equity market from a different perspective. That is, we focus not on

time variation in currency risk premium and exposure, but rather on the cash‐flow link

between currency movements and stock returns. Thus, the second and a more important

contribution is that we provide evidence that the underlying link between stock returns

and currency movements is the cash flow. This finding is not only new to the literature but

also plausible given the findings in Shapiro (1974), Dumas (1978), Levi (1990), and Hou,

Karolyi, and Kho (2011).

II. Data and Empirical Methodology

Data

We employ the cash flow measure that is commonly used in the literature (e.g.,

Lakonishok, Shleifer, and Vishny 1994; Fama and French 1996; McLean and

Zhao forthcoming). More specifically, cash flow is total earnings before extraordinary

items, plus equity’s share of depreciation, plus deferred taxes (if available). Following

McLean and Zhao (forthcoming), we standardize cash flows by total assets. For

robustness, we also standardize cash flows by sales or do not standardize cash flows at all.

In all cases, our results do not change qualitatively. The quarterly accounting data are

obtained from the Compustat database.

Following Francis, Hasan, and Hunter (2008), we focus on all NYSE, AMEX,

and NASDAQ stocks in the 36 industries that are most likely to be affected by currency

risk for the sample period from July 1980 to December 2008.

1

The monthly stock returns

data are obtained from the Center for Research in Security Prices (CRSP).

1

The 36 industries are made up of 31 traded‐goods (manufacturing) industries and 5 non‐traded‐goods

industries (entertainment, construction, meals, retail goods, and banking).

140 The Journal of Financial Research