The Implied Equity Duration When Discounting and Forecasting Parameters are Industry Specific

Abstract

In a seminal paper, Dechow, Sloan and Soliman (2004) develop a price-implied measure for equity duration and for its estimation they employ parsimonious but relatively crude procedures. Hence, these authors claim that improvements in procedures should lead to more accurate and useful estimates of their measure. Within this context, we estimate the implied equity duration 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. We show that when we move to estimation based on industry-specific parameters, significant differences arise in absolute, relative and rank terms. We also provide evidence that the new procedures improve the ability of implied equity duration to capture stock price risk. When we seek the source of this improvement, we find 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 given when implied equity duration based on market parameters performs poorly as a price-risk measure. Thus, we conclude that the cost of being parsimonious in estimating firms' duration is high on average and also quite variable across firms, both quantitatively and qualitatively. Moreover, this cost is large enough to reverse the duration-based ranking order of firms and to result in estimated durations without the ability to measure price risk.