The term structure of implied costs of equity capital

Jeffrey L. Callen; Matthew R. Lyle

doi:10.1007/s11142-019-09513-z

The term structure of implied costs of equity capital

Jeffrey L. Callen^*, Matthew R. Lyle

^*Corresponding author for this work

Accounting Information and Management

Research output: Contribution to journal › Article › peer-review

12 Scopus citations

Abstract

We model and estimate the term structure of implied costs of equity capital (and implied risk premia) at the firm level for the years 1996–2015 from forward looking option contracts. Empirical tests reject the assumption that the term structure of implied firm-level costs of equity is constant over different time horizons. Instead, we find that the term structure is often upward sloping and concave. However, we also find that the term structure flattened during the 1998 and 2007–2008 crises and even sloped downward during part of 2008. Term structure estimates are shown to predict future stock returns and volatilities over multiple horizons. In contrast to static implied cost of capital models, the term structure estimates can capture ex ante the well-documented earnings announcement premium. Moreover, various firm-level characteristics related to firm performance and risk are shown to explain some of the cross-sectional variation in the shape of the term structure.

Original language	English (US)
Pages (from-to)	342-404
Number of pages	63
Journal	Review of Accounting Studies
Volume	25
Issue number	1
DOIs	https://doi.org/10.1007/s11142-019-09513-z
State	Published - Mar 1 2020

Funding

We wish to acknowledge the referees of this Journal for their constructive insights. We also thank Peter Easton, the editor of this Journal, Judson Caskey, Rick Lambert, Miguel Minutti-Meza and Hila Fogel-Yaari for their comments. Thanks are also due to the participants of the following conferences and university seminars for their comments: FARS Chicago, CAAA Toronto, World Finance Rhodes, MFS Rome, IFBS Rome, Singapore Management University, Bocconi University, University of Minnesota, and Hong Kong Polytechnic University.

Keywords

Expected returns
Implied cost of equity capital
Option contracts
Term structure

ASJC Scopus subject areas

Accounting
General Business, Management and Accounting

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10.1007/s11142-019-09513-z

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title = "The term structure of implied costs of equity capital",

abstract = "We model and estimate the term structure of implied costs of equity capital (and implied risk premia) at the firm level for the years 1996–2015 from forward looking option contracts. Empirical tests reject the assumption that the term structure of implied firm-level costs of equity is constant over different time horizons. Instead, we find that the term structure is often upward sloping and concave. However, we also find that the term structure flattened during the 1998 and 2007–2008 crises and even sloped downward during part of 2008. Term structure estimates are shown to predict future stock returns and volatilities over multiple horizons. In contrast to static implied cost of capital models, the term structure estimates can capture ex ante the well-documented earnings announcement premium. Moreover, various firm-level characteristics related to firm performance and risk are shown to explain some of the cross-sectional variation in the shape of the term structure.",

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N2 - We model and estimate the term structure of implied costs of equity capital (and implied risk premia) at the firm level for the years 1996–2015 from forward looking option contracts. Empirical tests reject the assumption that the term structure of implied firm-level costs of equity is constant over different time horizons. Instead, we find that the term structure is often upward sloping and concave. However, we also find that the term structure flattened during the 1998 and 2007–2008 crises and even sloped downward during part of 2008. Term structure estimates are shown to predict future stock returns and volatilities over multiple horizons. In contrast to static implied cost of capital models, the term structure estimates can capture ex ante the well-documented earnings announcement premium. Moreover, various firm-level characteristics related to firm performance and risk are shown to explain some of the cross-sectional variation in the shape of the term structure.

AB - We model and estimate the term structure of implied costs of equity capital (and implied risk premia) at the firm level for the years 1996–2015 from forward looking option contracts. Empirical tests reject the assumption that the term structure of implied firm-level costs of equity is constant over different time horizons. Instead, we find that the term structure is often upward sloping and concave. However, we also find that the term structure flattened during the 1998 and 2007–2008 crises and even sloped downward during part of 2008. Term structure estimates are shown to predict future stock returns and volatilities over multiple horizons. In contrast to static implied cost of capital models, the term structure estimates can capture ex ante the well-documented earnings announcement premium. Moreover, various firm-level characteristics related to firm performance and risk are shown to explain some of the cross-sectional variation in the shape of the term structure.

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The term structure of implied costs of equity capital

Abstract

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ASJC Scopus subject areas

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