The Term Structure of Implied Costs of Equity Capital

66 Pages Posted: 12 Jan 2011 Last revised: 13 Feb 2019

Multiple version iconThere are 3 versions of this paper

Date Written: January 30, 2019

Abstract

We model and estimate the term structure of implied costs of equity capital (and implied risk premia) at the firm level for the years 1996-2015 from forward looking option contracts. Empirical tests reject the assumption that the term structure of implied firm-level costs of equity is constant over different time horizons. Instead, we find that the term structure is often upward sloping and concave. However, we also find that the term structure flattened during the 1998 and 2007-2008 crises periods and even sloped downward during part of 2008. Term structure estimates are shown to predict future stock returns and volatilities over multiple horizons. In contrast to static implied cost of capital models, the term structure estimates are able to capture ex ante the well-documented earnings announcement premium. Moreover, various firm-level characteristics related to firm performance and risk are shown to explain some of the cross-sectional variation in the shape of the term structure.

Keywords: Cost of Capital, Term Structure, Options

JEL Classification: G31, M41

Suggested Citation

Callen, Jeffrey L. and Lyle, Matthew R., The Term Structure of Implied Costs of Equity Capital (January 30, 2019). Rotman School of Management Working Paper No. 1738401, Available at SSRN: https://ssrn.com/abstract=1738401 or http://dx.doi.org/10.2139/ssrn.1738401

Jeffrey L. Callen

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
416-946-5641 (Phone)
416-971-3048 (Fax)

Matthew R. Lyle (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

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