A MACROECONOMIC ANALYSIS OF THE EARNINGS RESPONSE COEFFICIENT

Abstract

This thesis examines the variation of the earnings response coefficient (ERC) across the business cycle. With reference to discounted cash flow valuation models, changing expectations regarding earnings persistence across the business cycle could explain the variation of ERC. Past studies documented that earnings persistence, and thus ERC, is higher during expansionary periods than in recessionary periods. This is supported by our empirical results, suggesting that ERC is indeed higher during expansionary periods (good states) than in recessionary periods (bad states). We also explored the relationship between ERC and components of the expected rate of return, namely risk-free interest rate and market risk premium. Past studies suggested an inverse relationship between ERC and both components. The empirical results suggest that ERC has an inverse relationship with market risk premium. While we predicted that ERC would display an inverse relationship with risk-free interest rate, the observed results were inconsistent with our prediction.