The finance literature on the forecastibility of stock returns has concluded that stock market movements are, by and large, not due to changes in the expected future cash flow of firms, but are primarily due to changes in the risk premium, i.e. how the expected cash flows are discounted by stock market participants (Cochrane,2011). These changes in risk premia also have important implications for real variables in the economy, especially for consumption and investment. An increase in the risk premium prompts households to reduce current consumption as they start to discount expected future income more heavily.
More importantly, changes in the required return on equity alter the cost of capital of corporations when they finance new investment. For firms that rely on external debt to finance marginal investment, a lower stock price translates into lower net worth and thereforeahigher cost of borrowing (Bernankeetal., 1999). Similarly, firms that rely on new equity issues are able to raise less funds from each new share when their stock price is lower.
Even for firms that finance investment exclusively through internal funds (i.e. retained earnings plus depreciation allowance), the required return on existing shares reveals the opportunity cost of internally-financed investment (To bin, 1969, and To bin and Brainard, 1977). This is because, at least in principle, these funds can be returned to existing shareholders as dividends and new funds can then be raised from the markets through new equity shares for which investors would demand a risk premium.
In the aggregate, U.S. corporations are predominantly financed through equity. The dotted line in Figure 1 plots the credit market liabilities of U.S. non-financial corporations as a percent of the sum of equity and credit market liabilities in their balance sheets. By this measure, debt-financing accounts for about a third of total financing averaged over the whole sample, and equity-financing accounts for about two thirds.
The solid line in Figure 1 provides an alternative measure which takes into account all financial liabilities (including items such as trade payables), but nets out financial assets, to obtain a measure of net debt (McGrattan andPrescott, 2005). Now, debt-financing accounts for only 15%of total financing in the post-war period, and its importance has declined in the last two decades. Note that both of these series are stock measures as opposed to flow measures; i.e. they refer to financing of all past investments and do not necessarily reflect how corporations are financing investment at the margin. These measures can also be biased against debt-financing since most debt items are recorded onabook-value basis in the Flow of Funds, but equity is recorded on a market value basis.
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Identifying the Role of Risk Shocks in the Business Cycle Using Stock Price Data
