Time-varying state variable risk premia in the ICAPM

We find that the relation between state variables, such as the t-bill rate and term spread, and consumption growth is time-varying. In the cross-section of U.S. stocks, risk premia for exposure to state variables vary over time accordingly. When a state variable predicts consumption strongly relative to its own history, its annualized risk premium increases by 6% (0.4 in Sharpe ratio). This effect implies that risk premia can switch signs and are increasing in the conditional variance of the state variable. These common drivers of time-varying risk premia are consistent with the Intertemporal CAPM. Benchmark factors contain the same conditional expected return effects as state variable risk premia.     

Time-varying risk premia and the cross section of stock returns

This paper develops and estimates a heteroskedastic variant of Campbell’s [Campbell, J., 1993. Intertemporal asset pricing without consumption data. American Economic Review 83, 487–512] ICAPM, in which risk factors include a stock market return and variables forecasting stock market returns or variance. Our main innovation is the use of a new set of predictive variables, which not only have superior forecasting abilities for stock returns and variance, but also are theoretically motivated. In contrast with the early authors, we find that Campbell’s ICAPM performs significantly better than the CAPM. That is, the additional factors account for a substantial portion of the two CAPM-related anomalies, namely, the value premium and the momentum profit.     

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.     

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A general equilibrium model of changing risk premia: theory and tests

We derive and test a dynamic discrete-time model of asset returns.Both the risks of individual securities and equilibrium riskpremia change predictably in the model, but these changes canbe attributed to movements in the returns and prices of onlytwo well-diversified portfolios. Any other components of returnsshould be unpredictable. Using the generalized method of moments,the model is estimated and tested on portfolios of equities.We find the data supportive of the model's restrictions, evenwhen instruments designed to capture the January effect areemployed.     

Implied cost of capital investment strategies: evidence from international stock markets

Investors can generate excess returns by implementing trading strategies based on publicly available equity analyst forecasts. This paper captures the information provided by analysts by the implied cost of capital (ICC), the internal rate of return that equates a firm’s share price to the present value of analysts’ earnings forecasts. We find that U.S. stocks with a high ICC outperform low ICC stocks on average by 6.0 % per year. This spread is significant when controlling the investment returns for their risk exposure as proxied by standard pricing models. Further analysis across the world’s largest equity markets validates these results.     

Time-varying risk of rare disasters,investment, and asset pricing

We extend an equilibrium business cycle/asset pricing model of production and capital accumulation by introducing a time-varying risk of rare disasters. It predicts that investment is much more volatile than output, which provides theoretical support for the empirical data. Furthermore, the model-generated stationary distribution of the investment-output ratio fits the data remarkably well. Both of them exhibit negative skewness, which means that there is a small probability that this ratio can be very low. Given the observations of the investment-output ratio, we obtain the values of the jump intensity implicit in the historical data and find those recession periods coincide with a rapid increase in the probability of a disaster. Finally, the model shows that the existence of adjustment costs generates a procyclical price of capital and contributes to resolving the equity premium puzzle.     

A theory of voluntary disclosure and cost of capital

This paper explores the links between firms’ voluntary disclosures and their cost of capital. Existing studies investigate the relation between mandatory disclosures and cost of capital and find no cross-sectional effect but a negative association in time-series. In this paper, I find that when disclosure is voluntary firms that disclose their information have a lower cost of capital than firms that do not disclose, but the association between voluntary disclosure and cost of capital for disclosing and nondisclosing firms is positive in aggregate. I further examine whether reductions in cost of capital indicate improved risk-sharing or investment efficiency. I also find that high (low) disclosure frictions lead to overinvestment (underinvestment) relative to first-best. As average cost of capital proxies for risk-sharing but not investment efficiency, the relation between cost of capital and ex ante efficiency may be ambiguous and often irrelevant.     

Time-varying market,interest rate,and exchange rate risk premia in the US commercial bank stock returns

This paper examines the role of market, interest rate, and exchange rate risks in pricing a sample of the US Commercial Bank stocks by developing and estimating a multi-factor model under both unconditional and conditional frameworks. Three different econometric methodologies are used to conduct the estimations and testing. Estimations based on nonlinear seemingly unrelated regression (NLSUR) via GMM approach indicate that interest rate risk is the only priced factor in the unconditional three-factor model. However, based on ‘pricing kernel’ approach by Dumas and Solnik [(1995). J. Finance 50, 445–479], strong evidence of exchange rate risk is found in both large bank and regional bank stocks in the conditional three-factor model with time-varying risk prices. Finally, estimations based on the multivariate GARCH in mean (MGARCH-M) approach where both conditional first and second moments of bank portfolio returns and risk factors are estimated simultaneously show strong evidence of time-varying interest rate and exchange rate risk premia and weak evidence of time-varying world market risk premium for all three bank portfolios, namely those of Money Center bank, Large bank, and Regional bank.     

Accounting-based downside risk,cost of capital,and the macroeconomy

We hypothesize that earnings downside risk, capturing the expectation for future downward operating performance, contains distinct information about firm risk and varies with cost of capital in the cross section of firms. Consistent with the validity of the earnings downside risk measure, we find that, relative to low earnings downside risk firms, high earnings downside risk firms experience more negative operating performance over the subsequent period, are more sensitive to downward macroeconomic states, and are more strongly linked to earnings attributes and other risk-related measures from prior research. In line with our prediction, we also find that earnings downside risk explains variation in firms’ cost of capital, and that this link between earnings downside risk and cost of capital is incremental to several earnings attributes, accounting and risk factor betas, return downside risk, default risk, earnings volatility, and firm fundamentals. Overall, this study contributes to accounting research by demonstrating the key valuation and risk assessment roles of earnings downside risk derived from firms’ financial statements, also shedding new light on the link between accounting and the macroeconomy.     

Inflation risk premia and the expectations hypothesis

We study the properties of the nominal and real risk premia of the term structure of interest rates. We develop and solve the bond pricing implications of a structural monetary version of a real business cycle model, with taxes and endogenous monetary policy. We show the relation of this model with the class of essentially affine models that incorporate an endogenous state-dependent market price of risk. We characterize and estimate the inflation risk premium and find that over the last 40 years the ten-year inflation risk premium has been has averaged 70 basis points. It is time-varying, ranging from 20 to 140 basis points over the business cycle and its term structure is sharply upward sloping. The inflation risk premium explains 23% (42%) of the time variation in the five (ten)-year forward risk premium and it plays an important role in help explain deviations from the expectations hypothesis of interest rates.     

Fair insurance guaranty premia in the presence of risk-based capital regulations,stochastic interest rate and catastrophe risk

A multiperiod model is developed to measure the costs posed to the guaranty fund in a setting that incorporates risk-based capital regulations, interest rate risk and the possibility of catastrophic losses. The guaranty contract is modeled as a put option on the asset of the insurance company with a stochastic strike price and an uncertain maturity. The impacts of the key factors of this model are examined numerically and shown to make material differences in the costs to the guaranty fund.     

On time varying risk premia in the foreign exchange market: An econometric analysis

A generic intertemporal asset pricing model is applied in an international setting to generate a (possibly time varying) risk premium in the market for forward foreign exchange. The model is fitted and statistical tests of its general specification are performed. These specification tests provide weak evidence against the model.     

Time-varying beta risk of Pan-European industry portfolios: A comparison of alternative modeling techniques

This paper investigates the time-varying behavior of systematic risk for 18 pan-European sectors. Using weekly data over the period 1987–2005, six different modeling techniques in addition to the standard constant coefficient model are employed: a bivariate t-GARCH(1,1) model, two Kalman filter (KF)-based approaches, a bivariate stochastic volatility model estimated via the efficient Monte Carlo likelihood technique as well as two Markov switching models. A comparison of ex-ante forecast performances of the different models indicate that the random walk process in connection with the KF is the preferred model to describe and forecast the time-varying behavior of sector betas in a European context.     

The implied cost of equity capital,corporate investment and chief executive officer turnover

This study investigates how the cost of equity capital, along with corporate investment, affects chief executive officer (CEO) turnover decisions. We hypothesize that the cost of equity conveys information about firm performance uncertainty that is informative of CEO talent. Consistently, our empirical results show that the likelihood of CEO turnover is positively associated with the implied cost of equity, after controlling for earnings and stock performance measures and risk factors. Additional analysis of reverse causality supports the causal effect of the high cost of equity on CEO dismissals. We also find that the positive association is more pronounced for firms that are more likely to suffer from underinvestment problems. These results suggest that the cost of equity plays a more important role in assessing CEO performance when the firm needs more external equity capital to pursue investment opportunities.     

Macro-finance VARs and bond risk premia: A caveat

At the turn of the century, US and euro area long-term bond yields experienced a remarkable decline and remained at historically low levels despite rising short-term rates (the so called “conundrum”). Estimating macro-finance VARs and no-arbitrage term structure models, many researchers find that the decline in long-term rates was primarily driven by an unprecedented reduction in risk premia. I show that this result might be an artefact of the class of models employed to study the phenomenon.     

Foreign equity investment restrictions, capital flight, and shareholder wealth maximization: theory and evidence

This article provides a theory of foreign equity investmentrestrictions. We consider a model where the demand functionfor domestic shares differs between domestic and foreign investorsbecause of deadweight costs in holding domestic and foreignsecurities that depend on the country of residence of investors.We show that domestic entrepreneurs maximize firm value by discriminatingbetween domestic and foreign investors. The model implies thatcountries benefiting from capital flight have binding ownershiprestrictions such that foreign investors pay a higher pricefor shares than domestic investors. The empirical implicationsof this theory are supported by evidence from Switzerland.     

Cyclical variability of bond risk premia: A note

Using a newly developed model, this paper investigates the cyclical behavior of bond risk premia. It is shown that cyclical variability may result simply from the way risk premia are calculated and does not depend on changes over the business cycle in probability of default, investors' attitudes toward risk or institutional behavior. In addition, expectations concerning the likely time of default are shown to be a potential source of cyclical variability and to imply a specific cyclical pattern of risk premia.