DP5462 Estimating the Intertemporal Risk-Return Tradeoff Using the Implied Cost of Capital

Author(s): Lubos Pástor , Meenakshi Sinha , Bhaskaran Swaminathan

Publication Date: January 2006

Keyword(s): implied cost of capital , risk-return tradeoff , international integration

JEL(s): G1

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP5462.asp

We re-examine the time-series relation between the conditional mean and variance of stock market returns. To proxy for the conditional mean return, we use the implied cost of capital, computed using analyst forecasts. The usefulness of this proxy is shown in simulations. In empirical analysis, we construct the time series of the implied cost of capital for the G-7 countries. We find strong support for a positive intertemporal mean-variance relation at both the country level and the world market level. Some of our evidence is consistent with international integration of the G-7 financial markets.