Time-series Variation in Implied Costs of Capital: Evidence from Tests of Intertemporal Capital Asset Pricing Model Predictions
Prof. Lakshmanan (Shiva) Shivakumar
Lord David Sainsbury of Turville Professor
Professor of Accounting
London Business School
We study whether time variations in the implied costs of capital (ICC) align with the predictions of the intertemporal capital asset pricing model. The aggregate-level ICC in excess of the risk-free rate (ICC premium) incrementally predicts news about future GDP growth and consumption growth relative to other financial variables and risk proxies. Also, the co-movement of firm-level stock returns with changes in the ICC premium is significantly negatively priced in the cross-section. Further, this risk-premium tends to be larger when the ICC premium predicts consumption growth more strongly. These results support the ICC premium as a good proxy for time-varying expected market risk premium. However, investor sentiment also partly explains temporal variations in the ICC premium, suggesting that the ICC metrics do not reflect risk premium alone. When we reexamine prior evidence linking ICC metrics with future excess market returns (contemporaneous market volatility) to understand the drivers of the relationship, we find that macro news fully (partly) explains the relationship with excess market returns (market volatility).
