Does Corporate Investment Respond to Time-Varying Risk? Empirical Evidence

I test whether firms take time-varying risk into account in their capital budgeting decisions. The challenge to this test lies in measuring a conditional cost of equity. To do so, I nonparametrically estimate the firm-level equity premium implicit in individual equity option prices. The empirical analysis establishes that corporate investment responds negatively to fluctuations in the equity premium. This finding suggests that managers adjust their cost of capital correctly to time-varying risk, beyond depending entirely on the Capital Asset Pricing Model. I also provide empirical evidence supporting the hypothesis that time-varying risk causes corporate investment to negatively predict subsequent stock returns.