Economic Policy Uncertainty and the Cost of Equity Capital

Abstract

In this paper, we investigate the role of economic policy uncertainty (EPU) in the cost of equity capital. Our findings suggest that the relationship between EPU and the security market line varies cross-sectionally. Following periods of high EPU, the security market line tends to slope upward, whereas it exhibits a downward slope following periods of low EPU. In the time-series analysis, we observe that EPU significantly and positively affects the beta premium. Further evidence shows that investors may adjust their portfolios, shifting investments from higher-risk to lower-risk assets when confronted with high EPU.

Keywords: EPU, Market Beta, Beta Premium, Asset Allocation