How To Discount Cashflows With Time-Varying Expected Returns

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Overview: 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. A model is developed 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. It develops a valuation methodology, which incorporates time-varying risk premiums, betas and risk-free rates by computing a series of discount rates, which differ across maturity. The price of a security has an analytical solution, which depends only on observable instruments. It estimates the term structure of discount rates for book-to-market and industry portfolios, and find the effect of time-variation in risk-free rates, betas and risk premiums is large. At long horizons, the time-variation in risk-free rates or beta is more important. While the article provides an easily applicable methodology for handling the effects of time-varying risk premiums, risk-free rates and beta, and demonstrate that all these are important for valuation, future research must deal with some practical issues.

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Format: PDF | Size: 356KB | Date: Oct 2003 | Pages: 44