An Intertemporal CAPM with Stochastic Volatility

Abstract:     
This paper extends the approximate closed-form intertemporal capital asset pricing model of Campbell (1993) to allow for stochastic volatility. The return on the aggregate stock market is modeled as one element of a vector autoregressive (VAR) system, and the volatility of all shocks to the VAR is another element of the system. Our estimates of this VAR reveal novel low-frequency movements in market volatility tied to the default spread. We show that growth stocks underperform value stocks because they hedge two types of deterioration in investment opportunities: declining expected stock returns, and increasing volatility. Volatility hedging is also relevant for pricing risk-sorted portfolios and non-equity assets such as equity index options and corporate bonds.

Number of Pages in PDF File: 78

Keywords: ICAPM, time-varying expected returns, stochastic volatility, value premium

JEL Classification: G12, N22

working papers series