Market Equilibrium and the Cost of Capital with Heterogeneous Investment Horizons

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