Investigating Icapm with Dynamic Conditional Correlations

Abstract

This paper examines the intertemporal relation between expected return and risk for 30 stocks in the Dow Jones Industrial Average. The mean-reverting dynamic conditional correlation model of Engle (2002) is used to estimate a stock s conditional covariance with the market and test whetherthe conditional covariance predicts time-variation in the stock s expected return. The risk-aversion coefficient, restricted to be the same across stocks in panel regression, is estimated to be betweentwo and four and highly significant. This result is robust across different market portfolios, different sample periods, alternative specifications of the conditional mean and covariance processes, and including a wide variety of state variables that proxy for the intertemporal hedging demand component of the ICAPM. Risk premium induced by the conditional covariation of individual stocks with the market portfolio remains economically and statistically significant after controlling for risk premiums induced by conditional covariation with macroeconomic variables (federal funds rate, default spread, and term spread), financial factors (size, book-to-market, and momentum), and volatility measures (implied, GARCH, and range volatility).

Keywords: ICAPM, Dynamic conditional correlation, ARCH, Risk aversion, Dow Jones