Cost of Equity and State Uncertainty

Abstract

We propose a Bayesian framework to incorporate uncertainty about the state of the economy, and find that state uncertainty has economically significant effects on the estimation of the cost of equity. On average, a normal pricing model overestimates the cost of equity by 5% for utility firms, and 1.5% for industries. Consistent with Pastor and Stambaugh (1999), we find that the cost of equity is insensitive to mispricing uncertainty even in the presence of state uncertainty, but it is sensitive to state uncertainty regardless of the level of mispricing uncertainty. We also observe that the expected excess return, volatility, etc. display dynamics that coincide with the business cycles, and the latent state and the market predict the GDP growth rate six months ahead.