Testing International Asset Pricing Models Using Implied Costs of Capital

Abstract

This paper tests international asset pricing models using firm level expected returns estimated from the implied cost of capital approach and contrasts the results with those based on realized returns. Among G7 countries, we find that the implied cost of capital based expected returns are only one-tenth as volatile as those based on realized returns. As a result, while tests based on both implied cost of capital and realized returns produce economically similar findings, only tests based on implied cost of capital are statistically significant. Our results show that expected returns increase with world market beta, return volatility, financial leverage, and book-to-market ratios and decrease with currency beta and firm size. Overall, the evidence suggests that the implied cost of capital approach provides better insights into the cross-sectional determinants of firm-level expected returns in the international context.