# COSTS OF EQUITY CAPITAL: Model Uncertainty 3

We analyze the effects of model uncertainty using a range of values for aa, the prior within-model mispricing uncertainty, but each value of oa is held constant across models in order to limit the analysis to a manageable number of cases. Many more cases are possible, of course, since a decision maker’s prior uncertainty about […]

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- Aug, 30, 2014
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# COSTS OF EQUITY CAPITAL: Model Uncertainty 2

Let denote the posterior variance of ц obtained under model q. When estimating the expected excess return, the decision maker is left with overall uncertainty given by the unconditional posterior variance across models: The first term on the right-hand side of (42), the expected value across models of the posterior variance of /i, is essentially […]

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- Aug, 28, 2014
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# COSTS OF EQUITY CAPITAL: Model Uncertainty

The plots in Figure 7, for the CAPM versus the CK model, exhibit the highest correlation, but even those plots exhibit more dispersion than any of the top two plots in Figures 1 through 3. That is, the disagreement across models in estimates of expected excess returns appears to be greater than the disagreement within […]

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- Aug, 26, 2014
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# COSTS OF EQUITY CAPITAL: An Industry-Specific Approach 3

That is, the posterior means of a deviate from zero by similar amounts. This result combines two offsetting effects: the absolute values of a tend to be somewhat lower for utilities, but those a values receive relatively more weight in computing the posterior means. The latter effect arises from the utility-specific prior, wherein the prior […]

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- Aug, 24, 2014
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# COSTS OF EQUITY CAPITAL: An Industry-Specific Approach 2

The uncertainty about A is more important than the uncertainty about j3 and, not surprisingly, this difference is more pronounced for utilities than for a typical stock from the broad cross-section. Again with the CAPM as an example, the average conditional standard deviation of [3’X given A = A is about 0.57%, whereas the average […]

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- Aug, 22, 2014
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# COSTS OF EQUITY CAPITAL: An Industry-Specific Approach

We have redone the calculations for that case and find similar results, except that, not surprisingly, the estimate of the expected excess return is affected even less by a. In other words, for any economically reasonable prior uncertainty about mispricing, the estimate of the expected excess return is very close to the estimate produced by […]

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- Aug, 20, 2014
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# COSTS OF EQUITY CAPITAL: Results for a Broad Cross-Section 4

Recall that, for each of the three models, the estimate of the expected excess return for Bay State Gas is not very sensitive to the presence of economically plausible “pricing uncertainty,” represented by aa. As the results in Tables II-IV demonstrate, for values of aa up to 5%, the posterior mean of Bay State Gas’s […]

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- Aug, 18, 2014
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# COSTS OF EQUITY CAPITAL: Results for a Broad Cross-Section 3

In all three models, the posterior means of A are affected substantially by augmenting the factor histories, which begin in July 1963, with the longer histories of additional series that begin in 1926. These effects on posterior means indicate an important reliance on the information in the longer histories of the additional variables, but the […]

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- Aug, 16, 2014
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# COSTS OF EQUITY CAPITAL: Results for a Broad Cross-Section 2

Unless stated otherwise, our discussion in this subsection is confined to results obtained using the longer 1926-95 period. The FF and CK models yield posterior means of fi for the typical (average) stock in the range of 11% to 12%, roughly 3% higher than the corresponding mean under the CAPM. For the FF model, this […]

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- Aug, 14, 2014
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# COSTS OF EQUITY CAPITAL: Results for a Broad Cross-Section

Tables III and IV report posterior moments for the components of Bay State Gas’s expected excess return under the Fama-French (FF) model and the Connor-Korajczyk (CK) model. In general, the observations made above for the CAPM apply to these three-factor models as well. In particular, Bay State Gas’s a is 5.04% in the FF model […]

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- Aug, 12, 2014
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