DP3103 Time-Varying Risk Premia and the Cost of Capital: An Alternative Implication of the Q Theory of Investment

Author(s): Martin Lettau, Sydney Ludvigson
Publication Date: December 2001
Keyword(s): Investment, Q-Theory, risk premia
JEL(s): E22, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3103

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 emphasise 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.