The term structure of implied costs of equity capital

Review of Accounting Studies - 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...     

Removing predictable analyst forecast errors to improve implied cost of equity estimates

Prior research documents a weak association between the implied cost of equity inferred from analyst forecasts and realized returns. It points to predictable errors in analyst forecasts as a possible cause. We show that removing predictable errors from analyst forecasts leads to a much stronger association between implied cost of equity estimates obtained from adjusted forecasts and realized returns after controlling for cash flow news and discount rate news. An estimate of implied risk premium based on the average of four commonly used methods after making adjustments for predictable errors exhibits strong correlations with future realized returns as well as the lowest measurement error. Overall, our results confirm the validity of implied cost of equity estimates as measures of expected returns. Future research using implied cost of equity should remove predictable errors from implied cost of capital estimates and then average across multiple metrics.     

R&D expenditures and implied equity risk premiums

This study investigates the relationship between research and development (R&D) expenditures and risk premiums implied in the costs of equity capital. We posit that R&D expenditures represent an information risk factor resulting from both information asymmetry about R&D between investors and managers and low-quality R&D reporting that impairs the coordination between investors and managers with respect to managers’ investment decisions. Our results support our position by showing a positive association between R&D expenditures and implied equity risk premiums. From this research along with prior studies, investors can have better knowledge about the risky nature of R&D expenditures that drive up implied risk premiums and at the same time provide opportunities to earn excess returns in a short to long horizon. Accounting standard setters can benefit from this study’s findings that R&D expenditures represent an off-balance-sheet risk factor and thus warrant reconsidering SFAS No. 2 for potential capitalization of R&D expenditures.     

The equity premium implied by production

This paper studies the determinants of the equity premium as implied by producers’ first-order conditions. A simple closed form expression is presented for the Sharpe ratio as a function of investment volatility and technology parameters. Calibrated to the US postwar economy, the model can match the historical first and second moments of the market return and the risk-free interest rate. The model also generates a very volatile Sharpe ratio and market price of risk.     

The currency risk factor in international equity pricing

Currency risk in the pricing of international equity returns is analyzed from an empirical viewpoint. The significance of the domestic market index, and the world index is also analyzed. The methodology is based on the Asymptotic Principal Components when an approximate factor structure is assumed. Monthly stock price returns for five countries are used. Thirty stocks are chosen from each country. Fifteen years of data is used. The U.S. Dollar is the numeraire. Exchange risk is generally not priced. The Domestic market index is always priced. The pricing of the World Index is mixed, i.e., it is priced in certain case and not in others.     

Unconstrained estimates of the equity risk premium

Estimates of the equity risk premium implied by analyst forecasts—generally 2–4 %—are often significantly below realized equity returns of 6 %. Measurement error could result from conservative assumptions, reliance upon consensus rather than detailed forecasts, the use of market rather than target prices, and regression analysis, which can be influenced by a small number of observations. We address these potential sources of measurement error. Our estimates are consistent with subsequently realized returns and capture systematic risk exposure. Alternative techniques could capture another form of priced risk or identify firm characteristics associated with systematic mispricing. From 1999 to 2008, we estimate an average equity risk premium in the United States of 5.3 %. The estimate increases from 3.1 % for 1999–2000 to 5.9 % from 2001 to 2008, comparable to the historical average of realized equity returns.     

How do firms finance their investments?: The relative importance of equity issuance and debt contracting costs

This paper examines the financing decisions of firms in response to changes in investments and profits. We find that information frictions play important roles in firms' financing decisions. However, we find no evidence that asymmetric information about the value of a firm's assets causes equity to be used only as a last resort. Indeed equity is the predominant source of finance in situations, such as profit shortfalls, investment in intangible assets, and internally generated growth opportunities, where informational asymmetries and agency costs are likely to be high. We also find that firms respond asymmetrically to positive and negative profit shocks. In financing fixed assets, high asymmetric information firms use more short-term debt and less long-term debt, whereas firms with high potential agency problems use significantly more equity and less long-term debt and cash.     

Multivariate dependence of implied volatilities from equity options as measure of systemic risk

This paper presents a methodology to examine the multivariate tail dependence of the implied volatility of equity options as an early warning indicator of systemic risk within the financial sector. Using non-parametric methods of estimating changes in the dependence structure in response to common shocks affecting individual risk profiles, possible linkages during periods of stress are quantifiable while recognizing that large shocks are transmitted across financial markets differently than small shocks. Before and during the initial phase of the financial crisis, we find that systemic risk increased globally as early as February 2007 — months before the unraveling of the U.S. subprime mortgage crisis and long before the collapse of Lehman Brothers. The average (multivariate) dependence among a global sample of banks and insurance companies increased by almost 30% while joint tail risk declined by about the same order of magnitude, indicating that co-movements of large changes in equity volatility were more likely to occur and responses to extreme shocks became more differentiated as distress escalated. The key policy consideration flowing from our analysis is that complementary measures of joint tail risk at high data frequency are essential to the robust measurement of systemic risk, which could enhance market-based early warning mechanisms as part of macroprudential surveillance.     

Currency hedging failure in international equity investments and an efficient hedging strategy: The perspective of Korean investors

Korean fund investors suffered significant financial losses from their international equity investments during the recent global financial crisis. Contrary to expectations for improved investment performance, the currency position for hedging purposes worsened performance. In this paper, we critically assess currency-hedging practices for international equity investments from the perspective of Korean investors. We find that international equity portfolios are concentrated in a limited number of emerging market regions; most international equity funds employ near-fixed and near-perfect currency-hedging policies; the minimum-variance currency-hedging strategy performs the best in emerging market regions and its relative gains over the current hedging policy are significant; the no-hedging strategy provides the best performance for the investments into the US and Europe during a turbulent period.     

Heterogeneous time varying transaction costs and asset pricing in international equity markets

In this paper, we examine the time variation in transaction costs relative to excess returns, in a panel consisting of 10 international equity indices over the time period 1984–2005. This is undertaken by extending the consumption CAPM (CCAPM) model proposed by Campbell and Shiller (Rev. Financ. Stud. 1:195–228, 1988) to incorporate time varying proportional transaction costs. We rigorously address both the cross-country heterogeneity in the estimated model and endogeneity. We find strong evidence that suggests transaction costs should be included as an additional explanatory variable in the CCAPM. This leads to the conclusion that transaction costs should be included in asset pricing models as their stochastic process impacts directly on private consumption expenditure.

Analyst recommendations and the implied cost of equity

We investigate the relation between analyst recommendations and the cost of equity implied by current stock price and earnings forecasts. Contrary to expectations, previous-year recommendation upgrades are associated with increases in the current cost of equity; and past increases in the cost of equity are associated with current recommendation downgrades. Furthermore, changes in the implied cost of equity and changes in analyst recommendations jointly explain as much as 31% of the variation in 1-year holding period returns, where most of the variation (28%) is explained by the implied cost of equity alone. We document that when forming recommendations, analysts underestimate the role of the cost of equity.     

Degrees-of-freedom problem and implied cost of equity capital

Bias in implied cost of equity estimates arises from analyst optimism and a degrees-of-freedom problem. The common practice in empirical studies of using a proxy for the earnings forecast horizon beyond two years in the Ohlson and Juettner-Nauroth (OJ) model is potentially biased. We derive a generalized OJ model over a T period forecast horizon and indicate the extent of this bias. The implied cost of equity capital is obtained from a quadratic equation, where our constant term comprises T short-term annual earnings per share growth rates, rather than just the next-period counterpart in the OJ model.     

The effect of mergers on implied volatility of equity options

This paper uses a sample of 25 large mergers from 1996 to 2004 to study the effect of mergers on the implied volatilities of equity options. The results indicate a statistically significant increase in volatility beyond the amount predicted if the transaction were effectively nothing more than a portfolio combination of the target and acquirer. The disparity suggests that, at least for the first 18 months after the transaction becomes effective, market participants expect mergers to increase risk. Integration risk and uncertainty about the extent to which efficiency gains and greater market power are realized are possible explanations for the discrepancy.     

Jump risk premia across major international equity markets

We decompose the non-diversifiable market risk into continuous and discontinuous components and jump systematic risks into positive vs. negative and small vs. large components. We examine their association with equity risk premia across major equity markets. We show that developed markets jumps are more closely linked to the aggregate market index than emerging and frontier ones. The reward for bearing both the continuous and downside jump risks is positive during the pre-crisis period whereas the reward for bearing the upside and large jump risks is negative during the crisis and post-crisis periods. We also provide evidence of significant continuous and discontinuous leverage effects during the pre-crisis period, suggesting that both continuous and discontinuous price and volatility risks share compensations for common underlying risk factors.     

Risk and return of short-duration equity investments

We analyze short-duration equity investments using traded claims on index dividends. We show that investment strategies with constant short maturity outperform a systematic long position in the underlying equity index on a risk-adjusted basis and in absolute terms. Furthermore, we find higher international diversification benefits for this strategy, compared to traditional equity indices. We relate the observed outperformance to market downside exposure, in particular an options-based downside risk factor. We use three alternative models to extract ex-ante risk premia implied in the prices of dividend derivatives and find evidence for substantial time variation in expected returns.     

Fixed costs and long-lived investments

Fixed costs models are difficult to analyze because they feature non-degenerate, time-varying distributions of capital across firms. If investments are sufficiently long-lived however then the cross-sectional distribution of capital holdings has virtually no bearing on the equilibrium and the aggregate behavior of fixed-cost models is essentially identical to neoclassical models. The findings are due to a near infinite elasticity of investment timing for long-lived investments – a feature shared by fixed-cost models and neoclassical models. “Irrelevance results” found in numerical studies of fixed-cost models are not parametric special cases but instead are fundamental properties of models with long-lived investment goods.     

Contracts and returns in private equity investments

We analyze the relationship between contracts and returns in private equity (PE) investments. Contractual control in the form of covenants tends to be employed to identify good deals. Better quality firms are more likely to have covenant-rich contracts, as they are less concerned by the constraints imposed by the covenants. PE investors appoint closer associates of the fund in deals that are performing poorly but tend to outsource board governance in better deals. Collectively, our evidence suggests that PE investors operate along two dimensions, choosing covenants and board seats differently, based on the ex ante quality of the company.     

Option implied volatilities and the cost of issuing equity

The structure of a firm-commitment Seasoned Equity Offering (SEO) resembles a put-option underwritten by an investment bank syndicate (Smith, 1977). Employing implied volatilities from issuers’ stock options as a direct forward-looking measure, this paper examines the impact of expected price risk around SEO issue dates on the direct cost of issuing equity. Using a comprehensive sample of 1208 SEOs between 1996 and 2009, we find issuers with higher option implied volatilities raise less external equity capital and pay higher investment bank fees in the stock market, ceteris paribus. The effect of implied volatility on the investment bank fees is stronger for larger issuers with lower pre-SEO abnormal realized stock volatilities, and for SEOs with higher expected price pressures around issue dates. These relationships are robust to adjustments for correlations among control variables, sample selection bias and also simultaneous determination of offer size and SEO fees.     

The implied jump risk of LIBOR rates

This paper examines implied parameters from options on LIBOR futures. Jump-diffusion models are found to offer superior in-sample and out-of-sample performance when compared to their pure diffusion counterpart. The need to incorporate stochastic jump magnitudes into LIBOR dynamics is also documented. In addition, empirical evidence reveals that the jump component in LIBOR rates is important for pricing their derivatives. Furthermore, variation in jump risk often coincides with Federal Open Market Committee (FOMC) decisions and a small subset of macroeconomic announcements.     

The dynamics of international equity market expectations

This paper develops a noisy rational expectations model of the way in which international investors adjust their expectations of asset payoffs in a given country in response not only to public information signals but also to private information signals whose precision differs across investors. The model predicts that the perceptions of investors in one country about the future market returns in another country are related differently to realized past returns depending on their informational disadvantage relative to other investors: the greater is that informational disadvantage, the greater is the change in perception associated with returns. The predictions are confirmed by monthly survey data of institutional money managers investing in developed markets from 1995 to 2000.