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Time-Varying Risk Premia and the Cost of Capital: An Alternative Implication of the Q Theory of Investment

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Author Info
Lettau, Martin
Ludvigson, Sydney

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Abstract

Evidence suggests that expected excess stock market returns vary over time, and that this variation is much larger than that of expected real interest rates. It follows that a large fraction of the movement in the cost of capital in standard investment models must be attributable to movements in equity risk premia. In this Paper we emphasise that such movements in equity risk premia should have implications not merely for investment today, but also for future investment over long horizons. In this case, predictive variables for excess stock returns over long-horizons are also likely to forecast long-horizon fluctuations in the growth of marginal Q, and therefore investment. We test this implication directly by performing long-horizon forecasting regressions of aggregate investment growth using a variety of predictive variables shown elsewhere to have forecasting power for excess stock market returns.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3103.

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Date of creation: Dec 2001
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Handle: RePEc:cpr:ceprdp:3103

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Related research
Keywords: Investment; Q-Theory; risk premia;

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Find related papers by JEL classification:
E22 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Capital; Investment; Capacity
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

References listed on IDEAS
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Jorge Selaive & Vicente Tuesta, 2004. "Can Fluctuations in the Consumption-Wealth Ratio Help to Predict Exchange Rates?," International Finance 0404014, EconWPA. [Downloadable!]
    Other versions:
  2. Thomas Philippon, 2006. "The Bond Market's q," NBER Working Papers 12462, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. Hui Guo & Robert Savickas, 2006. "Idiosyncratic volatility, economic fundamentals, and foreign exchange rates," Working Papers 2005-025, Federal Reserve Bank of St. Louis. [Downloadable!]
  4. Jeremy J. Nalewaik, 2004. "Current Consumption and Future Income Growth: Synthetic Panel Evidence," BEA Working Papers 0015, Bureau of Economic Analysis. [Downloadable!]
  5. Lettau, Martin & Ludvigson, Sydney, 2001. "Measuring and Modelling Variation in the Risk-Return Trade-off," CEPR Discussion Papers 3105, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  6. Gomes, Joao F & Yaron, Amir & Zhang, Lu, 2002. "Asset Pricing Implications of Firms' Financing Constraints," CEPR Discussion Papers 3495, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  7. Simon Price & Christoph Schleicher, . "Returns to equity, investment and Q: evidence from the United Kingdom," Bank of England working papers 310, Bank of England. [Downloadable!]
  8. Simon Price, 2004. "UK investment and the return to equity: Q redux," Money Macro and Finance (MMF) Research Group Conference 2004 87, Money Macro and Finance Research Group. [Downloadable!]
  9. Javier Gómez Pineda, . "Inflation Targeting, Sudden Stops and the Cost of Fear of Floating," Borradores de Economia 276, Banco de la Republica de Colombia. [Downloadable!]
  10. Colin Ellis & Simon Price, 2004. "UK business investment: long-run elasticities and short-run dynamics," Money Macro and Finance (MMF) Research Group Conference 2003 27, Money Macro and Finance Research Group. [Downloadable!]
    Other versions:
  11. François Gourio, 2009. "Disasters Risk and Business Cycles," NBER Working Papers 15399, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  12. Javier Gómez, 2004. "Inflation Targeting and Sudden Stops," BORRADORES DE ECONOMIA 002854, BANCO DE LA REPÚBLICA. [Downloadable!]
  13. Demetrios Eliades & Olaf Weeken, . "The stock market and capital accumulation: an application to UK data," Bank of England working papers 251, Bank of England. [Downloadable!]
  14. Long Chen & Lu Zhang, 2007. "Neoclassical Factors," NBER Working Papers 13282, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  15. Stephen Millard & John Power, . "The effects of stock market movements on consumption and investment: does the shock matter?," Bank of England working papers 236, Bank of England. [Downloadable!]
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