Sustainability managed against downside risk and the cost of equity: Evidence in Korea

Abstract

This study examines the relationship between sustainability managed against downside risk and the cost of equity in the Korean stock market during the 2000-2016 period. We employ downside co-skewness and downside beta as a measure of downside risk, to analyze the cross-sectional relationship between them and average portfolio stock returns. We have also carried out Fama-MacBeth regressions to find the required return for bearing downside risk. The results show that downside co-skewness can be used more effectively than downside beta to explain a cross-section of stock returns or cost of equity. The required premium for bearing downside risk, as measured by downside co-skewness, is approximately 19% per annum in the Korean stock market. This finding suggests that sustainable companies can raise their capital in the form of equity at 19% lower costs, and also implies that increasing sustainability can reduce the cost of capital.