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

Authors

  • ĽUBOŠ PÁSTOR,

  • MEENAKSHI SINHA,

  • BHASKARAN SWAMINATHAN

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    • Ľuboš Pástor is at the Graduate School of Business at the University of Chicago, NBER, and CEPR. Meenakshi Sinha is at Cornerstone Research. Bhaskaran Swaminathan is at LSV Asset Management and the Johnson Graduate School of Management at Cornell University. Helpful comments were gratefully received from Ray Ball, George Constantinides, Doug Diamond, Gene Fama, Christian Leuz, Toby Moskowitz, Rob Stambaugh, Pietro Veronesi, Robert Whitelaw, Franco Wong, the anonymous referee, the anonymous associate editor who acted as editor, and the audiences at the University of British Columbia, the University of Chicago accounting workshop, the University of Chicago finance lunch workshop, and the 2005 meetings of the Western Finance Association.

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.

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