Estimation Risk, Information, and the Conditional CAPM: Theory and Evidence

Abstract

We theoretically and empirically investigate the role of information on the cross section of stock returns and firms' cost of capital when investors face estimation risk and learn from noisy signals of uncertain quality. The resultant equilibrium is an information-dependent conditional CAPM. We find strong empirical support for the model. Innovations in market volatility, oil prices, exchange rates, and dispersion of analysts' forecasts not only help explain the cross section of stock returns, but their influence depends on the stock's systematic estimation risk. Moreover, dividend and share repurchase initiations have significant downward announcement effects on estimated betas and their standard errors. (JEL D83, D92, E22) How investors process new return-related information and how this information affects equilibrium asset prices is a central issue in finance; it is of substantial interest not only to financial economists seeking to understand the informational efficiency of security prices, but also to investment practitioners who must make investment decisions in the face of continually arriving information. In the textbook capital asset pricing model (CAPM), which assumes that the investment opportunity set is common knowledge, prices simply adjust to new information so as to fall along the new security pricing line. However, this model of information absorption (in security markets) is not satisfactory from