The Implied Equity Term Structure

Abstract

We propose a new methodology to estimate the equity term structure, based on the cross-section of stock prices and the implied cost of capital approach. Specifically, instead of focusing on the realized returns of maturity-specific dividend assets, we imply the term structure of expected returns based on the observed market prices and projected firm-level cash flows. Using US data for 1976-2019, we find an unconditionally upward sloping term structure of risk premia with rich cross-sectional patterns. Namely, large and growth firms exhibit an upward sloping term structure, whereas the smallest and value firms mostly have a downward sloping term structure. We also detect that the slope of the term structure changes from negative to positive in the late 1990s for the largest firms, as well as that the slope tends to flatten out or even invert in recessions. Thus, using a direct measure of ex-ante returns, we are able to provide new evidence on the debated properties of the equity term structure.