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http://ssrn.com/abstract=1738401
 
 

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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

January 30, 2014

Rotman School of Management Working Paper No. 1738401

Abstract:     
We model and estimate the term structure of implied costs of equity capital (and implied risk premia) at the …rm level for the years 1996-2012, using inter alia synthetic futures prices derived from forward looking option contracts. Empirical tests reject the assumption that implied …rm-level costs of equity are constant over different horizons. Instead, we find that the term structure of implied costs of equity are upward sloping and concave for most years and industries. Interestingly, we also fi…nd that the term structure of implied costs of equity ‡flattened during the 2008-2009 crisis period. We validate the firm-level term structure estimates by reference to future realized equity returns. Consistent with our estimates being valid costs of equity proxies, we …find a robust association between our estimates and future equity returns. Both cross-sectional and time-series asset pricing tests indicate that our time-varying implied costs of equity capital are positively and significantly associated with future equity returns in contrast to traditional static implied and factor model costs of equity which are not associated with future equity returns. We also derive a long-term implied cost of equity capital from the term structure pattern that outperforms standard implied cost of capital estimates. We further show that the term structure model, in contrast to other models, predicts risk premia for the month of earnings announcements consistent with recent literature.

Number of Pages in PDF File: 62

Keywords: Cost of Capital, Term Structure, Options

JEL Classification: G31, M41

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Date posted: January 12, 2011 ; Last revised: March 5, 2014

Suggested Citation

Callen, Jeffrey L. and Lyle, Matthew R., The Term Structure of Implied Costs of Equity Capital (January 30, 2014). Rotman School of Management Working Paper No. 1738401. Available at SSRN: http://ssrn.com/abstract=1738401 or http://dx.doi.org/10.2139/ssrn.1738401

Contact Information

Jeffrey L. Callen
University of Toronto - Rotman School of Management ( email )
105 St. George Street
Toronto, Ontario M5S 3E6
Canada
416-946-5641 (Phone)
416-971-3048 (Fax)
Matthew R. Lyle (Contact Author)
Kellogg School of Management ( email )
2001 Sheridan Road
Evanston, IL 60208
United States
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