State uncertainty in stock markets: How big is the impact on the cost of equity?
AbstractWe propose a novel Bayesian framework to incorporate uncertainty about the state of the market. Among others, one advantage of the framework is the ability to model a large collection of time-varying parameters simultaneously. When we apply the framework to estimate the cost of equity we find economically significant effects of state uncertainty. A state-independent pricing model overestimates the cost of equity by about 4% per annum for a utility firm and by as much as 3% for industries. We also observe that the expected return, volatility, risk loading, and pricing error all display state-dependent dynamics that coincide with the business cycle. More interestingly, the forecasted market and Fama–French factor risk premiums can predict the future real GDP growth rate even though the model does not use any macroeconomic variables, which suggests that the proposed Bayesian framework captures the state-dependent dynamics well.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Banking & Finance.
Volume (Year): 36 (2012)
Issue (Month): 9 ()
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Web page: http://www.elsevier.com/locate/jbf
Cost of capital; Time-varying parameters; State uncertainty; Dirichlet process; Bayesian analysis;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
- C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
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