The Cost of Capital of Cross‐listed Firms

This paper analyses the cost of capital of firms with foreign equity listings. Our purpose is to shed light on the question whether international and domestic asset pricing models yield a different estimate of the cost of capital for cross‐listed stocks. We distinguish between (i) the multifactor ICAPM of Solnik (1979) and Sercu (1980) including both the global market portfolio and exchange rate risk premia and (ii) the single factor domestic CAPM. We test for the significance of the cost of capital differential in a sample of 336 cross‐listed stocks from nine countries in the period 1980–99. Our hypothesis is that the cost of capital differential is substantial for firms with international listings, as these are often large multinationals with a strong international orientation. We find that the asset pricing models yield a significantly different estimate of the cost of capital for only 12% of the cross‐listed companies. The size of the cost of capital differential is around 50 basis points for the US, 80 basis points for the UK and 100 basis points for France.     

Book‐to‐Market Equity,Asset Correlations and the Basel Capital Requirement

This paper examines the effect of book‐to‐market equity (BE/ME) on asset correlations under the Basel capital requirement. We find that BE/ME captures variations in asset correlations after controlling for firm size, default probability and industry effects from 1987 to 2011. Obligors with higher BE/ME exhibit lower asset correlations compared to those with lower BE/ME. Decomposing BE/ME into assets‐in‐place and growth options based on the asset pricing literature shows that obligors with more assets‐in‐place or more fixed assets have higher BE/ME and lower asset correlations than those with more growth options. Overall, our findings suggest that BE/ME is an additional important factor that may improve the estimates of asset correlations and thereby banks’ capital adequacy.     

Estimating the Cost of Equity for Property-Liability Insurance Companies

Due to the highly skewed and heavy‐tailed distributions associated with the insurance claims process, we evaluate the Rubinstein‐Leland (RL) model for its ability to improve the cost of equity estimates of insurance companies because of its distribution‐free feature. Our analyses show that there is as large as a 94‐basis‐point difference in the estimated cost of insurance equity between the RL model and the capital asset pricing model (CAPM) for the sample of property‐liability insurers with more severe departures from normality. In addition, consistent with our hypotheses, significant differences in the market risk estimates are found for insurers with return distributions that are asymmetrically distributed, and for small insurers. Third, we find significant performance improvements from using the RL model by showing smaller values of excess return of the expected return of the portfolio to the model return for a portfolio of insurers with returns that are more skewed and for a portfolio of small insurers. Finally, our panel data analysis shows the differences in the market risk estimates are significantly influenced by firm size, degree of leverage, and degree of asymmetry. The implication is that insurers should use the RL model rather than the CAPM to estimate its cost of capital if the insurer is small (assets size is less than $2,291 million), and/or its returns are not symmetrical (the value of skewness is greater than 0.509 or less than ?0.509).     

Estimating the Cost of Equity Capital for Property-Liability Insurers

This article presents new evidence on the cost of equity capital by line of insurance for the property‐liability insurance industry. To do so we obtain firm beta estimates and then use the full‐information industry beta (FIB) methodology to decompose the cost of capital by line. We obtain full‐information beta estimates using the standard one‐factor capital asset pricing model and extend the FIB methodology to incorporate the Fama–French three‐factor cost of capital model. The analysis suggests the cost of capital for insurers using the Fama–French model is significantly higher than the estimates based upon the CAPM. In addition, we find evidence of significant differences in the cost of equity capital across lines.     

Do a firm's equity returns reflect the risk of its pension plan?

This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.     

Industry‐Specific Human Capital,Idiosyncratic Risk,and the Cross‐Section of Expected Stock Returns

Human capital is one of the largest assets in the economy and in theory may play an important role for asset pricing. Human capital is heterogeneous across investors. One source of heterogeneity is industry affiliation. I show that the cross‐section of expected stock returns is primarily affected by industry‐level rather than aggregate labor income risk. Furthermore, when human capital is excluded from the asset pricing model, the resulting idiosyncratic risk may appear to be priced. I find that the premium for idiosyncratic risk documented by several empirical studies depends on the covariance between stock and human capital returns.     

Neural networks for estimating Macro Asset Pricing model in football clubs

The recent crisis caused by COVID-19 directly affected consumption habits and the stability sof financial markets. In particular, the football industry has been hit hard by this pandemic and therefore has more volatile stock prices. Given this new scenario, further research is needed to accurately estimate the value of the shares of football clubs. In this paper, we estimate an asset pricing model in football clubs with different compositions of risk nature using non-linear techniques of artificial neural networks. Usually, asset pricing models have been estimated with linear methods such as ordinary least squares. Our results show a precision higher than 90% for all the estimated models, which far exceeds those shown by linear methods in the previous literature. We find that the residual represents about 40% of the variance of the price-dividend ratio. Long-term risks follow in importance, and above all, the habit component and its behaviour in the face of changes. The importance of the residual component exists due to a low correlation between the asset price and consumer behaviour, but to a much lesser extent than that shown in previous studies. The estimation carried out with artificial neural networks, both the Deep Learning methods and especially the Quantum Neural Network, opens up new possibilities to estimate more efficiently the pricing of financial assets in the football industry.     

Equilibrium asset pricing: with non-Gaussian factors and exponential utilities

We analyse the equilibrium asset pricing implications for an economy with single period return exposures to explicit non-Gaussian systematic factors, that may be both skewed and long-tailed, and Gaussian idiosyncratic components. Investors maximize expected exponential utility and equilibrium factor prices are shown to reflect exponentially tilted prices for non-Gaussian factor risk exposures. It is shown that these prices may be directly estimated from the univariate probability law of the factor exposure, given an estimate of average risk aversion in the economy. In addition, a residual form of the capital asset pricing model continues to hold and prices the idiosyncratic or Gaussian risks. The theory is illustrated on data for the US economy using independent components analysis to identify the factors and the variance gamma model to describe the probability law of the non-Gaussian factors. It is shown that the residual CAPM accounts for no more than 1% of the pricing of risky assets, while the exponentially tilted systematic factor risk exposures account for the bulk of risky asset pricing.     

Sorting, Firm Characteristics, and Time-varying Risk: An Econometric Analysis

We show that sorting reveals the time-varying market risk exposuresof the firm-specific investment opportunity set. Sorting onthe basis of firm characteristics uncovers information on firm-specificdistress or growth, and this leads to more efficient estimationof conditional risk sensitivity. We demonstrate the effectivenessof the sorting methodology with an empirical exercise that teststhe conditional capital asset pricing model (CAPM). When measuredproperly using sorting and firm characteristics, conditionalbetas, along with size and the book-market ratio, are significantdrivers of expected returns.     

The evolution of capital asset pricing models

The capital asset pricing models (CAPM) has been the benchmark of asset pricing models and has been used to calculate asset returns and the cost of capital for more than four decades. Many researchers have tried to relax the original assumptions and generalize the static CAPM. We survey the important alternative theoretical models of capital asset pricing and provide a complete review of the evolution of asset pricing models. We also discuss the interrelationships among these models and suggest several possible directions for future research. Our results might be used as a guideline for future theoretical and empirical research in capital asset pricing.     

Determinants of market beta: the impacts of firm-specific accounting figures and market conditions

This article examines and extends research on the relation between the capital asset pricing model market beta, accounting risk measures and macroeconomic risk factors. We employ a beta decomposition approach that nests competing models with different business risk proxies and allows to frame cross-model comparison. Because model tests require estimated independent variables resulting in measurement error, we empirically estimate three comparable model specifications with instrumental variable estimators and for the first time provide thorough instrument diagnostics in this setting. Correcting for the heretofore neglected weak instruments problem we find that growth risk (i.e., the risk of firm sales variations that are inconsistent with the market wide trends), is the business risk that explains cross-sectional variations in market beta best.     

Security prices in a production economy with durable capital

Security prices and physical stocks of capital are determined jointly in a rational expectations economy as functions of a set of exogenous stochastic factors. Investors employ firm marginal productivity of capital to allocate savings across firms. Firm capital stocks adjust to exogenous shocks across many periods. Security price functions in period t are derived in the cases of constrained and unconstrained firm capital in t. The risk premia in security returns include two sets of terms. One set, corresponding to traditional asset pricing models, relates cash flows directly to the stochastic factors. The second set captures interfirm effects which arise because firm capital in each period t is durable.     

Firm characteristics and the impact of emerging market liberalizations

We provide a firm level analysis of the impact of capital market liberalization in 18 emerging markets. Consistent with models of international asset pricing, we find that firms’ stock returns increase during liberalization and that a majority of firms have lower mean returns and lower dividend yields after liberalization. We also find that emerging market firms have increased exposure to the world market and decreased exposure to the home market following liberalization. These changes in returns and exposures support the predictions of theoretical international asset pricing models. We also test and find support for the importance of size, local risk, foreign exchange risk, and cross-listing status in explaining the cross-section of changes in returns.     

Inventory investment and the cost of capital

We examine the relation between inventory investment and the cost of capital in the time series and the cross section. We find consistent evidence that risk premiums, rather than real interest rates, are strongly negatively related to future inventory growth at the aggregate, industry, and firm levels. The effect is stronger for firms in industries that produce durables rather than nondurables, exhibit greater cyclicality in sales, require longer lead times, and are subject to more technological innovation. We then construct a production-based asset pricing model with two types of capital, fixed capital and inventories, to explain these empirical findings. Convex adjustment costs and a countercyclical price of risk lead to negative time series and cross-sectional relations between expected returns and inventory growth.     

Estimating the Divisional Cost of Capital: An Analysis of the Pure-Play Technique

This paper suggests that the pure-play technique can be used in conjunction with the capital asset pricing model to determine the cost of equity capital for the divisions of a multidivision firm. Since the beta for a division is unobservable in the marketplace, a proxy beta derived from a publicly traded firm whose operations are as similar as possible to the division in question is used as the measure of the division's systematic risk. To provide empirical support for using the pure-play technique, a sample of multidivision firms and pure-play associated with each division is examined. It is shown that an appropriately weighted average of the betas of the pure-play firms closely approximates the beta of the multidivision firm.     

Cash demand,liquidation costs and capital market equilibrium under uncertainty

In this paper, the portfolio and the liquidity planning problems are unified and analyzed in one model. Stochastic cash demands have a significant impact on both the composition of an individual's optimal portfolio and the pricing of capital assets in market equilibrium. The derived capital asset pricing model with cash demands and liquidation costs shows that both the market price of risk and the systematic risk of an asset are affected by the aggregate cash demands and liquidity risk. The modified model does not require that all investors hold an identical risky portfolio as implied by the Sharpe-Lintner-Mossin model. Furthermore, it provides a possible explanation for the noted discrepancies between the empirical evidence and the prediction of the traditional capital asset pricing model.     

Allocation of Capital in the Insurance Industry

ABSTRACT: This article discusses and critiques the methods that have been proposed for allocating capital in financial institutions, with an emphasis on applications in the insurance industry. The author discusses the rationale for allocating capital by line of business and explains how capital allocation can be used to maximize firm value. The implications for capital allocation of regulatory risk-based capital and the capital asset pricing model are discussed. The advantages and disadvantages of using value-at-risk and insolvency put option criteria in capital allocation are analyzed. Finally, recently proposed methods of marginal capital allocation are evaluated. One conclusion is that using the insolvency put option is superior to value-at-risk for allocating capital but that both methods fail to account for diversification across lines in the multi-line firm. The primary conclusion is that marginal capital allocation methodologies based on option-pricing models that recognize the effects of diversification are the best approach for allocating capital in the financial industry.     

Common risk factors in bank stocks

This paper provides evidence on the risk factors that are priced in bank equities. Alternative empirical models with precedent in the nonfinancial asset pricing literature are tested, including the single-factor CAPM, three-factor Fama–French model, and ICAPM. Our empirical results indicate that an unconditional two-factor ICAPM model that includes the stock market excess return and shocks to the slope of the yield curve is useful in explaining the cross-section of bank stock returns. However, we find no evidence that firm specific factors such as size and book-to-market ratios are priced in bank stock returns. These results have a number of important implications for the estimation of the banks’ cost of capital as well as regulatory initiatives to utilize market discipline to evaluate bank risk under Basel II.     

The intertemporal capital asset pricing model with dynamic conditional correlations

The intertemporal capital asset pricing model of Merton (1973) is examined using the dynamic conditional correlation (DCC) model of Engle (2002). The mean-reverting DCC model is used to estimate a stock’s (portfolio’s) conditional covariance with the market and test whether the conditional covariance predicts time-variation in the stock’s (portfolio’s) expected return. The risk-aversion coefficient, restricted to be the same across assets in panel regression, is estimated to be between two and four and highly significant. The risk premium induced by the conditional covariation of assets with the market portfolio remains positive and significant after controlling for risk premia induced by conditional covariation with macroeconomic, financial, and volatility factors.     

The pricing of capital assets in a multiperiod world

This paper proposes a general framework for the pricing of capital assets in a multiperiod world. Under quite general conditions, the analysis shows that the equilibrium expected nominal return on any asset can always be expressed as the sum of the risk-free rate and various risk premiums. The first risk premium is identical to the usual risk premium in the Sharpe-Lintner-Mossin capital asset pricing model. The mathematical forms of all the remaining risk premiums are identical even though each individual risk premium may be present for a different reason.