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Estimating the Intertemporal Risk–Return Tradeoff Using the Implied Cost of Capital

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  • ĽUBOŠ PÁSTOR
  • MEENAKSHI SINHA
  • BHASKARAN SWAMINATHAN

Abstract

We argue that the implied cost of capital (ICC), computed using earnings forecasts, is useful in capturing time variation in expected stock returns. First, we show theoretically that ICC is perfectly correlated with the conditional expected stock return under plausible conditions. Second, our simulations show that ICC is helpful in detecting an intertemporal risk–return relation, even when earnings forecasts are poor. Finally, in empirical analysis, we construct the time series of ICC for the G–7 countries. We find a positive relation between the conditional mean and variance of stock returns, at both the country level and the world market level.

Suggested Citation

  • Ľuboš Pástor & Meenakshi Sinha & Bhaskaran Swaminathan, 2008. "Estimating the Intertemporal Risk–Return Tradeoff Using the Implied Cost of Capital," Journal of Finance, American Finance Association, vol. 63(6), pages 2859-2897, December.
  • Handle: RePEc:bla:jfinan:v:63:y:2008:i:6:p:2859-2897
    DOI: 10.1111/j.1540-6261.2008.01415.x
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