The Term Structure of Implied Costs of Equity Capital
Jeffrey L. Callen
University of Toronto - Rotman School of Management
Matthew R. Lyle
Kellogg School of Management
July 29, 2011
We model and estimate the term structure of implied costs of equity capital (expected returns) and implied risk premia at the firm-level for the years 1996-2009 using data extracted from forward looking option contracts. Model-free estimation methods are employed to extract a term structure of expected cash flows and equity risks from the options data. The estimation procedures are chosen to capture skewness in implied volatilities across strike prices for each maturity and remove the potential variance premium bias that may be present in the risk neutral variances. We find that the term structures of implied costs of equity capital and implied risk premia are upward sloping and concave for most years and industries. Interestingly, we also find that the term structure of implied costs of equity capital (risk premia) are downward sloping for the crisis period 2008 (2008-2009). We further validate the term structure cost of capital estimates by reference to future stock returns. Cross-sectional and time-series asset pricing tests indicate that time varying implied costs of equity capital are positively and significantly associated with future stock returns. In contrast, more traditional cost of capital benchmarks are either not associated with future stock returns or the associations are less robust than the term structure estimates.
Number of Pages in PDF File: 47
Keywords: Term Structure, Implied Costs of Equity, Cash Flow Risk
JEL Classification: M41, G30
Date posted: October 27, 2010 ; Last revised: August 8, 2011
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