ConsumptionRiskandtheCostofEquityCapitalRavi.pdfVIP

USC FBE FINANCE SEMINAR presented by Ravi Jagannathan FRIDAY, April 22, 2005 10:30 am – 12:00 pm, Room: JKP-104 Consumption Risk and the Cost of Equity Capital Ravi Jagannathan Yong Wang Northwestern University Northwestern University University of Southern California April, 2005 Motivation Model Results Conclusion 1 Motivation Historical average returns vary substantially across different asset classes There are significant differences even within equities For example, during 1954-2003: • Small Growth stocks earned 6.19 % per year, and • Small Value stocks earned 17.19 % over the risk free asset. In a perfect and informationally efficient market, • Realized average returns provide a good measure of what investors expected to earn • Assets that are expected to earn higher return would have higher exposure to systematic risk In such a world assets with higher average risk premium should have higher exposure to systematic risk Jagannathan Wang Consumption Risk and the Cost of Equity Capital 1 Motivation Model Results Conclusion 1.1 Measuring Exposure to Systematic Risk Standard Economic Theory • Covariance between the return on an asset and aggregate per capita consumption growth rate measures exposure to systematic risk Consumption CAPM