Cash flows, currency risk, and the cost of capital

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.