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 rm level for the years 1996-2012, using inter alia synthetic futures prices derived from forward looking option contracts. Empirical tests reject the assumption that implied rm-level costs of equity are constant over different horizons. Instead, we find that the term structure of implied costs of equity are upward sloping and concave for most years and industries. Interestingly, we also fi nd that the term structure of implied costs of equity ‡flattened during the 2008-2009 crisis period. We validate the firm-level term structure estimates by reference to future realized equity returns. Consistent with our estimates being valid costs of equity proxies, we find a robust association between our estimates and future equity returns. Both cross-sectional and time-series asset pricing tests indicate that our time-varying implied costs of equity capital are positively and significantly associated with future equity returns in contrast to traditional static implied and factor model costs of equity which are not associated with future equity returns. We also derive a long-term implied cost of equity capital from the term structure pattern that outperforms standard implied cost of capital estimates. We further show that the term structure model, in contrast to other models, predicts risk premia for the month of earnings announcements consistent with recent literature.