Testing International Asset Pricing Models Using Implied Costs of Capital

Abstract This paper tests international asset pricing models using firm-level expected returns estimated from an implied cost of capital approach. We show that the implied approach provides clear evidence of economic relations that would otherwise be obscured by the noise in realized returns. Among G-7 countries, expected returns based on implied costs of capital have less than one-tenth the volatility of those based on realized returns. Our tests show that firm-level expected returns increase with world market beta, idiosyncratic volatility, financial leverage, and book-to-market ratios, and decrease with currency beta and firm size.