TY - JOUR

T1 - Time-varying risk premia and the cost of capital

T2 - An alternative implication of the Q theory of investment

AU - Lettau, Martin

AU - Ludvigson, Sydney

PY - 2002

Y1 - 2002

N2 - Evidence suggests that expected excess stock market returns vary over time, and that this variation is much larger than that of expected real interest rates. It follows that a large fraction of the movement in the cost of capital in standard investment models must be attributable to movements in equity risk-premia. In this paper we emphasize that such movements in equity risk premia should have implications not merely for investment today, but also for future investment over long horizons. In this case, predictive variables for excess stock returns over long-horizons are also likely to forecast long-horizon fluctuations in the growth of marginal Q, and therefore investment. We test this implication directly by performing long-horizon forecasting regressions of aggregate investment growth using a variety of predictive variables shown elsewhere to have forecasting power for excess stock market returns.

AB - Evidence suggests that expected excess stock market returns vary over time, and that this variation is much larger than that of expected real interest rates. It follows that a large fraction of the movement in the cost of capital in standard investment models must be attributable to movements in equity risk-premia. In this paper we emphasize that such movements in equity risk premia should have implications not merely for investment today, but also for future investment over long horizons. In this case, predictive variables for excess stock returns over long-horizons are also likely to forecast long-horizon fluctuations in the growth of marginal Q, and therefore investment. We test this implication directly by performing long-horizon forecasting regressions of aggregate investment growth using a variety of predictive variables shown elsewhere to have forecasting power for excess stock market returns.

KW - Investment

KW - Q-theory

KW - Risk-premia

UR - http://www.scopus.com/inward/record.url?scp=0036147289&partnerID=8YFLogxK

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U2 - 10.1016/S0304-3932(01)00097-6

DO - 10.1016/S0304-3932(01)00097-6

M3 - Article

AN - SCOPUS:0036147289

VL - 49

SP - 31

EP - 66

JO - Carnegie-Rochester Confer. Series on Public Policy

JF - Carnegie-Rochester Confer. Series on Public Policy

SN - 0304-3932

IS - 1

ER -