Using empirical evidence, the authors demonstrate that volatility carries a positive risk premium. In fact, as volatility increases, the discount rate rises. This change leads to a higher cost of capital, thereby stunting the market’s long-term economic growth. To capture this effect, the authors unveil their Macro-DCAPM-SV model, which is an update to the traditional capital asset pricing model.
What’s Inside?
The authors introduce their newly formed Macro-DCAPM-SV model, a dynamic pricing model with three sources of risk: cash flow risk, discount rate risk, and volatility risk. Similar to Merton’s intertemporal capital asset pricing model (CAPM), the authors’ new Macro-DCAPM-SV model contains multi-beta pricing. But the authors take the concept a step further by creating a model that can use both the relevant risk factors and their prices. Not only is this groundbreaking from an empirical standpoint, but it also allows the model to capture short-term fluctuations as well as long-term risks.
Next, the authors demonstrate the importance of including volatility in the CAPM. Using detailed research, they show that substantial misspecifications can occur when volatility is excluded from an analysis. Given that an increase in volatility is associated with a significant decline in realized and expected consumption, the effect of ignoring volatility from a CAPM analysis can be quite costly.
How Is This Research Useful to Practitioners?
The CAPM is the cornerstone of many areas of finance, from equity research to business valuations. In equity research, the CAPM is used in determining the appropriate cost of equity, which is used in the weighted average cost of capital (WACC) equation to determine whether a stock is under- or overvalued. In business valuation, the CAPM is, again, used to determine the cost of equity that is used in the WACC, which is then used in the process of allocating the purchase price to different assets on the balance sheet. In both settings, the CAPM provides a foundational element to valuation, and experts rely on the capital asset pricing model extensively.
With their new, enhanced version of the CAPM, the authors uncover a potentially more accurate and complete rendering of this widely respected and accepted model.
How Did the Authors Conduct This Research?
The authors use a number of figures and research studies in support of their findings. Quite compelling is their table called “Asset Pricing Implications of the Macro-DCAPM-SV Model.” The table breaks down the sources of risk for both growth and value firms as well as large and small firms. It demonstrates that the contribution of volatility risk is most significant for the growth portfolio as well as the large-firm portfolio, accounting for 60% and 70% of the total premium, respectively. In contrast, for value firms as well as for small firms, the volatility risk only accounts for 30% of the total premium. Thus, without volatility risk, premiums would be much smaller and would fail to reflect the true risk.
Abstractor’s Viewpoint
The authors provide a very convincing argument to support their thesis that markets with higher volatility risk demand a higher discount rate. They also unveil a newly formulated capital asset pricing model that provides an arguably more comprehensive approach to determining the cost of equity. The tables and figures display compelling evidence that supports the authors’ conclusion. I applaud the authors for selecting tables and figures that target the issue from a variety of angles, providing a comprehensive and nonrepetitive review of both the topic and the implications for investors.