Working Paper: NBER ID: w10042
Authors: Andrew Ang; Jun Liu
Abstract: While many studies document that the market risk premium is predictable and that betas are not constant, the dividend discount model ignores time-varying risk premiums and betas. We develop a model to consistently value cashflows with changing risk-free rates, predictable risk premiums and conditional betas in the context of a conditional CAPM. Practical valuation is accomplished with an analytic term structure of discount rates, with different discount rates applied to expected cashflows at different horizons. Using constant discount rates can produce large mis-valuations, which, in portfolio data, are mostly driven at short horizons by market risk premiums and at long horizons by time-variation in risk-free rates and factor loadings.
Keywords: cash flows; discount rates; time-varying risk premiums; CAPM; valuation
JEL Codes: E43; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| time-varying risk premiums (G19) | cash flow valuation (G19) |
| time-varying betas (C22) | cash flow valuation (G19) |
| risk-free rates (E43) | cash flow valuation (G19) |
| market risk premium (G17) | cash flows (G19) |
| changes in betas (C46) | mispricing of cash flows (G19) |
| variations in risk premium (G19) | mispricing of cash flows (G19) |
| time-variation of expected returns (C22) | cash flow valuation (G19) |