Hostname: page-component-8448b6f56d-xtgtn Total loading time: 0 Render date: 2024-04-25T04:13:47.347Z Has data issue: false hasContentIssue false
  • English
  • Français

Testing International Asset Pricing Models Using Implied Costs of Capital

Published online by Cambridge University Press:  01 April 2009

Charles Lee ,
David Ng  and
Bhaskaran Swaminathan
Charles Lee
Affiliation:
Advanced Strategies and Research, Barclays Global Investors, 400 Howard St., San Francisco, CA 94105. professor.lee@gmail.com
David Ng
Affiliation:
Department of Applied Economics and Management, Cornell University, 252 Warren Hall, Ithaca, NY 14853. dtn4@cornell.edu
Bhaskaran Swaminathan
Affiliation:
LSV Asset Management, One North Wacker Dr., Chicago, IL 60606. swami@lsvasset.com
Get access Rights & Permissions [Opens in a new window]

Abstract

This paper tests international asset pricing models using firm-level expected returns estimated from an implied cost of capital approach. We show that the implied approach provides clear evidence of economic relations that would otherwise be obscured by the noise in realized returns. Among G-7 countries, expected returns based on implied costs of capital have less than one-tenth the volatility of those based on realized returns. Our tests show that firm-level expected returns increase with world market beta, idiosyncratic volatility, financial leverage, and book-to-market ratios, and decrease with currency beta and firm size.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 44 , Issue 2 , April 2009 , pp. 307 - 335
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2009

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Adler, M., and Dumas, B.. “International Portfolio Choice and Corporation Finance: A Synthesis.” Journal of Finance, 38 (1983), 925–984.CrossRefGoogle Scholar
Ang, A., and Bekaert, G.. “Stock Return Predictability: Is It There?” Review of Financial Studies, 20 (2007), 651–707.CrossRefGoogle Scholar
Ang, A.; Hodrick, R.; Xing, Y.; and Zhang, X.. “The Cross-Section of Volatility and Expected Returns.” Journal of Finance, 61 (2006), 259–299.CrossRefGoogle Scholar
Ang, A.; Hodrick, R.; Xing, Y.; and Zhang, X.. “High Idiosyncratic Volatility and Low Returns: International and Further U.S. Evidence.” Journal of Financial Economics, 91 (2009), 1–23.CrossRefGoogle Scholar
Ang, J., and Ciccone, S. J.. “International Differences in Analyst Forecast Properties.” Working Paper, Florida State University (2001).CrossRefGoogle Scholar
Banz, R. “The Relationship Between Return and Market Value of Common Stocks.” Journal of Financial Economics, 9 (1981), 3–18.CrossRefGoogle Scholar
Bekaert, G., and Harvey, C. R.. “Time-Varying World Market Integration.” Journal of Finance, 50 (1995), 403–444.Google Scholar
Bhandari, L. C. “Debt/Equity Ratio and Expected Common Stock Returns: Empirical Evidence.” Journal of Finance, 43 (1988), 507–528.CrossRefGoogle Scholar
Bossaerts, P., and Hillion, P.. “Implementing Statistical Criteria to Select Return Forecasting Models: What Do We Learn?” Review of Financial Studies, 12 (1999), 405–428.CrossRefGoogle Scholar
Botosan, C., and Plumlee, M.. “Assessing Alternative Proxies for the Expected Risk Premium.” Accounting Review, 80 (2005), 21–53.CrossRefGoogle Scholar
Brealey, R., and Myers, S.. Principles of Corporate Finance. Boston, MA: Irwin McGraw-Hill (2000).Google Scholar
Chan, L. K.; Karceski, J.; and Lakonishok, J.. “The Risk and Return from Factors.” Journal of Financial and Quantitative Analysis, 33 (1998), 159–188.CrossRefGoogle Scholar
Chan, L. K.; Karceski, J.; and Lakonishok, J.. “The Level and Persistence of Growth Rates.” Journal of Finance, 58 (2003), 643–684.CrossRefGoogle Scholar
Chan, K. C.; Karolyi, G. A.; and Stulz, R. M.. “Global Financial Markets and the Risk Premium on U.S. Equity.” Journal of Financial Economics, 32 (1992), 137–168.CrossRefGoogle Scholar
Claus, J., and Thomas, J.. “Equity Premia as Low as Three Percent? Evidence from Analysts’ Earnings Forecasts for Domestic and International Stock Markets.” Journal of Finance, 56 (2001), 1629–1666.CrossRefGoogle Scholar
Daniel, K.; Hirshleifer, D.; and Subrahmanyam, A.. “Overconfidence, Arbitrage, and Equilibrium Asset Pricing.” Journal of Finance, 56 (2001), 921–965.CrossRefGoogle Scholar
Daniel, K., and Titman, S.. “Evidence on the Characteristics of Cross Sectional Variation in Stock Returns.” Journal of Finance, 52 (1997), 1–33.CrossRefGoogle Scholar
Daniel, K.; Titman, S; and Wei, K.. “Explaining the Cross-Section of Stock Returns in Japan: Factors or Characteristics.” Journal of Finance, 56 (2001), 743–766.CrossRefGoogle Scholar
Davis, J.; Fama, E.; and French, K.. “Characteristics, Covariances, and Average Returns: 1929 to 1997.” Journal of Finance, 55 (2000), 389–406.CrossRefGoogle Scholar
De Moor, L., and Sercu, P.. “The Small Firm Anomaly: U.S. and International Evidence.” Working Paper, KU Leuven (2006).CrossRefGoogle Scholar
De Santis, G., and Gerard, B.. “How Big Is the Premium for Currency Risk?” Journal of Financial Economics, 49 (1998), 375–412.CrossRefGoogle Scholar
Dumas, B., and Solnik, B.. “The World Price of Foreign Exchange Risk.” Journal of Finance, 50 (1995), 445–479.CrossRefGoogle Scholar
Easton, P. “PE Ratios, PEG Ratios, and Estimating the Implied Expected Rate of Return on Equity Capital.” Accounting Review, 79 (2004), 73–95.CrossRefGoogle Scholar
Elton, E. J. “Expected Return, Realized Return, and Asset Pricing Tests.” Journal of Finance, 54 (1999), 1199–1220.CrossRefGoogle Scholar
Errunza, V., and Losq, E.. “International Asset Pricing under Mild Segmentation: Theory and Test.” Journal of Finance, 40 (1985), 105–124.CrossRefGoogle Scholar
Fama, E., and French, K. R.. “The Cross-Section of Expected Stock Returns.” Journal of Finance, 47 (1992), 427–465.Google Scholar
Fama, E., and French, K. R.. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), 3–56.CrossRefGoogle Scholar
Fama, E., and French, K. R.. “Value versus Growth: The International Evidence.” Journal of Finance, 53 (1998), 1975–1999.CrossRefGoogle Scholar
Fama, E., and French, K. R.. “The Equity Premium.” Journal of Finance, 57 (2002), 637–659.CrossRefGoogle Scholar
Ferson, W., and Harvey, C. R.. “The Risk and Predictability of International Equity Returns.” Review of Financial Studies, 6 (1993), 527–566.CrossRefGoogle Scholar
Frankel, R., and Lee, C.. “Accounting Diversity and International Valuation.” Working Paper, Cornell University (1999).Google Scholar
Gebhardt, W.; Lee, C.; and Swaminathan, B.. “Toward an Implied Cost of Capital.” Journal of Accounting Research, 39 (2001), 135–176.CrossRefGoogle Scholar
Gode, D., and Mohanram, P.. “Inferring the Cost of Capital Using the Ohlson-Juettner Model.” Review of Accounting Studies, 8 (2003), 399–431.CrossRefGoogle Scholar
Goyal, A., and Welch, I.. “Predicting the Equity Premium with Dividend Ratios.” Management Science, 49 (2003), 639–654.CrossRefGoogle Scholar
Griffin, J. “Are the Fama and French Factors Global or Country Specific?” Review of Financial Studies, 15 (2002), 783–803.CrossRefGoogle Scholar
Guay, W.; Kothari, S. P.; and Shu, S.. “Properties of Implied Cost of Capital Using Analysts’ Forecasts.” Working Paper, University of Pennsylvania (2005).Google Scholar
Hail, L., and Leuz, C.. “International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?” Journal of Accounting Research, 44 (2006), 485–531.CrossRefGoogle Scholar
Harvey, C. R. “The World Price of Covariance Risk.” Journal of Finance, 46 (1991), 111–157.CrossRefGoogle Scholar
Heston, S.; Rouwenhorst, K. G.; and Wessels, R.. “The Structure of International Stock Returns and the Integration of Capital Markets.” Journal of Empirical Finance, 2 (1995), 173–197.CrossRefGoogle Scholar
Hou, K.; Karolyi, G. A.; and Kho, B.. “What Factors Drive Global Stock Returns? ” Working Paper, Ohio State University (2006).CrossRefGoogle Scholar
Ince, O., and Porter, R.. “Individual Equity Return Data from Thomson Datastream: Handle with Care!” Journal of Financial Research, 29 (2006), 463–479.CrossRefGoogle Scholar
Jorion, P. “The Pricing of Exchange Rate Risk in the Stock Market.” Journal of Financial and Quantitative Analysis, 26 (1991), 363–376.CrossRefGoogle Scholar
Jorion, P., and Schwartz, E.. “Integration vs. Segmentation in the Canadian Stock Market.” Journal of Finance, 41 (1986), 603–614.CrossRefGoogle Scholar
Karolyi, G. A., and Stulz, R.. “Are Financial Assets Priced Locally or Globally?” In Handbook of the Economics of Finance, Constantinides, G. M., Harris, M., and Stulz, R. M., eds. Amsterdam: North Holland-Elsevier (2003), 975–1020.Google Scholar
Lakonishok, J.; Shleifer, A.; and Vishny, R. W.. “Contrarian Investment, Extrapolation, and Risk.” Journal of Finance, 49 (1994), 1541–1578.CrossRefGoogle Scholar
Malkiel, B., and Xu, Y.. “Idiosyncratic Risk and Security Returns.” Working Paper, Princeton University (2002).Google Scholar
Merton, R. “On Estimating the Expected Return on the Market: An Exploratory Investigation.” Journal of Financial Economics, 8 (1980) 323–361.CrossRefGoogle Scholar
Modigliani, F., and Miller, M. H.. “The Cost of Capital, Corporation Finance and the Theory of Investment.” American Economic Review, 48 (1958), 261–297.Google Scholar
Nissim, D., and Penman, S. H.. “Ratio Analysis and Equity Valuation: From Research to Practice.” Review of Accounting Studies, 6 (2001), 109–154.CrossRefGoogle Scholar
Ohlson, J., and Juettner-Nauroth, B. E.. “Expected EPS and EPS Growth as Determinants of Value.” Review of Accounting Studies, 10 (2005), 349–365.CrossRefGoogle Scholar
Pastor, L.; Sinha, M.; and Swaminathan, B.. “Estimating the Intertemporal Risk-Return Tradeoff Using the Implied Cost of Capital.” Journal of Finance, 63 (2008), 2859–2897.CrossRefGoogle Scholar
Sercu, P. “A Generalization of the International Asset Pricing Model.” Revue de l’Association Francaise de Finance, 1 (1980), 91–135.Google Scholar
Solnik, B. “An Equilibrium Model of the International Capital Market.” Journal of Economic Theory, 8 (1974), 500–524.CrossRefGoogle Scholar
Spiegel, M., and Wang, X.. “Cross-Sectional Variation in Stock Returns: Liquidity and Idiosyncratic Risk.” Working Paper, Yale University (2006).Google Scholar
Stulz, R. “A Model of International Asset Pricing.” Journal of Financial Economics, 9 (1981), 383–406.CrossRefGoogle Scholar
Zhang, X. “Specification Tests of International Asset Pricing Models.” Journal of International Money and Finance, 25 (2006), 275–307.CrossRefGoogle Scholar