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

  • LUBOS PÁSTOR
  • MEENAKSHI SINHA
  • BHASKARAN SWAMINATHAN

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. Copyright (c) 2008 The American Finance Association.

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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 63 (2008)
Issue (Month): 6 (December)
Pages: 2859-2897

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Handle: RePEc:bla:jfinan:v:63:y:2008:i:6:p:2859-2897
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