The implied equity duration when discounting and forecasting parameters are industry specific

Abstract

We estimate the implied equity duration using industry‐specific parameters. We provide evidence that this procedure improves the ability of implied equity duration to capture stock price risk. We show that it is due to a better capture of both the market risk and residual risk of the market asset pricing model. As expected, the higher the difference in the estimates of duration, the higher the improvement in measuring price risk, but the results also show that the highest improvements are obtained when the usual implied equity duration estimation based on market parameters performs poorly as a price risk measure.

Performance of Alternative Estimation Procedures of the Implied Equity Duration in a Small Stock Market

“…Our results support that the evidence found by Fullana et al [4] in the US stock market is also in a small stock market as the Spanish. The use of industry-specific parameters instead of market parameters leads to significant changes in the firms' IEDs.…”

“…where α' is the SGR long-run autocorrelation coefficient, and g is the long-run mean of SGR. Note, as Fullana et al [4] did, that the IED estimation per se does not require market parameters. However, DSS [1] used for all firms the same historical market averages of ROE and SGR estimated autocorrelation coefficients and the same historical market averages of return-on-equity and GDP growth as proxies of the long-run autocorrelations and long-run means, respectively.…”

“…However, as conceded by DSS [1], improvements in their procedures should lead to more accurate and useful estimates of the measure. Concerning this, Fullana, Nave, and Toscano [4] estimated the DSS [1] implied equity duration measure for the US market, but using industry-specific parameters for forecasting and discounting the future cash flows of listed firms as opposed to the market-estimated parameters used previously by DSS [1]. These authors showed that when they move to IED estimations based on industry-specific parameters, significant differences arise in absolute, relative, and rank terms.…”

“…Fullana et al [4] sought the source of this improvement in the context of the market asset-pricing model. These authors found that industry-specific IED better captures all the components of stock price risk in this valuation model, and, as it is expected, higher differences in the duration estimations imply higher improvements in price risk measurements.…”

“…The aim of this paper is to check whether the effects, both qualitative and quantitative, of using industry-specific parameters when computing the IED of US firms also occur when we compute the IED of firms listed in a small stock market. Our central hypothesis is that, in a small stock market, there is less variety in the firms listed and perhaps the parsimony of DSS [1] procedures may actually result in greater precision in the IED estimates, or at least sufficient for adequately ranked listed companies To achieve it, we built this paper on the Fullana and Toscano [5] research by applying to their data new procedures to estimate the parameters involved in IED computation as in [4].…”