Should the cost of capital have a significant impact on real economic activity? Basic finance teaches corporate managers to evaluate new investment opportunities based on the net present value of expected future cash flows. As the standard finance course cautions, this discount rate must be adjusted for the risk of the new project. If managers of risky firms are cognizant of their investors’ required compensation for risk, an increase in the risk premium should raise the “hurdle rate” managers use to evaluate new investments. Consequently, an increase in the risk premium could quash many investments already planned and reduce the number of new feasible projects. On a macroeconomic level, the consequences of a rise in the hurdle rate should include a reduction in new durable orders, employment, industrial production, and consumption. We test these hypotheses and analyze how changes in the premium investors demand to bear risk affects subsequent real economic activity.
Our work is related to research on the stock market’s ability to predict future macroeconomic conditions (Barro (1990), Fama (1981), and Lee (1992)). If a stock’s value represents the present value of its expected future dividends as implied by Lucas (1978), rational investors should bid up and down stock values based on their expectations of firms’ profits. As firm profitability is highly correlated with future economic prosperity, a procyclical relationship between real activity and the stock market should be seen. In our work, we take the study of this interaction in a new direction by recognizing that stock market value may be decomposed into two components: One component is the expected future disbursement of firm profits, i.e., dividends. The second is the risk-adjusted interest rate that discounts these cash flows. The stock market is therefore a confounded measure of time-variant risk-adjusted discount rates and future firm cash flows. We extract the risk-premium component and examine its impact on real economic activity.
The work of Lettau and Ludvigson (2002) and Lamont (2000) also focuses on investment decisions and their relationship to the risk premium. The analysis of Lettau and Ludvigson uses Q theory and a consumption wealth ratio to proxy for the future risk premium and then analyzes the link between this proxy and future long-term investment. Lamont sheds light on a puzzle in post-war data: investment and stock returns are negatively contemporaneously correlated. He tests the conjecture that firms need to plan investments. Actual investing occurs with a lag following a change in the discount rate and induces the observed negative correlation. Using surveys of firm investment plans, Lamont demonstrates that planned investment rises as the stock market rises and risky discount rates fall, just as financial economic reasoning would imply.
In contrast, we measure the dynamic multifactor risk premia directly using the Fama and French (1993) asset pricing model and test whether these premia have implications for future real economic activity including new durable goods orders and housing starts. One advantage of our approach is that it frames the question within the asset pricing literature, the results of which drive corporate managers’ financial decision-making. The Capital Asset-Pricing Model (CAPM) and, more recently, the intertemporal CAPM (ICAPM) and the Arbitrage Pricing Theory (APT) form the standard framework managers use to calculate the risk-adjusted cost of capital. As standard practice dictates, the decision to invest is then made by either comparing the investment’s internal rate of return against this hurdle rate or calculating the investment’s net present value by discounting at this rate. We explicitly extract the risk premium component of such a capital budgeting analysis. A second advantage is our use of an ICAPM framework (Fama and French view their model as a version of the ICAPM) wherein valid state variables must act as predictors of changing consumption investment opportunities. A priori, such a model is well suited to the study of linkages between asset pricing and future macroeconomic fluctuations.
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Investor Risk Premia and Real Macroeconomic Fluctuations
