Market Equilibrium and the Cost of Capital with Heterogeneous Investment Horizons

Moshe Levy and Haim Levy ()
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Moshe Levy: Jerusalem School of Business, The Hebrew University, Jerusalem 91905, Israel
Haim Levy: Jerusalem School of Business, The Hebrew University, Jerusalem 91905, Israel

Risks, 2024, vol. 12, issue 3, 1-16

Abstract: Expected returns, variances, betas, and alphas are all non-linear functions of the investment horizon. This seems to be a fatal conceptual problem for the capital asset pricing model (CAPM), which assumes a unique common horizon for all investors. We show that under the standard assumptions, the theoretical CAPM equilibrium surprisingly holds with the 1-period parameters, even when investors have heterogeneous and possibly much longer horizons. This is true not only for risk-averse investors, but for any investors with non-decreasing preferences, including prospect theory investors. Thus, the widespread practice of using monthly betas to estimate the cost of capital is theoretically justified.

Keywords: investment horizon; cost of capital; stochastic dominance; capital asset pricing model (CAPM); prospect theory (search for similar items in EconPapers)
JEL-codes: C G0 G1 G2 G3 K2 M2 M4 (search for similar items in EconPapers)
Date: 2024
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