Risk, expected return, and the cost of equity capital

Abstract

In applying the Capital Asset Pricing Model (CAPM) to cost of capital calculations, practitioners treat the market risk premium as a free parameter to be estimated from data. However, this process ignores equilibrium in the cash market and therefore the implications of the CAPM for the premium itself Full equilibrium relates the premium to underlying fundamental parameters, a finding that holds out the promise of identifying time‐variation in the cost of capital. Unfortunately, this yields extremely volatile cost of capital estimates, thereby casting doubt on the risk‐return tradeoff specified by the CAPM.

Notes

NZ Institute for the Study of Competition and Regulation, Victoria University of Wellington, PO Box 600, Wellington. [email protected] fax [phone]

I am grateful to Russell Investment Group Ltd for providing me with data used in this study. For helpful comments, I am indebted to two NZEP anonymous referees, Paul Hocking, Martin Lally, Leo Krippner, Abdullah Mamum, Alireza Tourani‐Rad, and participants at NZ Finance Colloquium and ISCR seminars. Hanqing Wang provided invaluable research assistance. Despite all this assistance, the responsibility for any remaining errors or ambiguities is mine alone.