An Intertemporal CAPM with Stochastic Volatility
John Y. Campbell
Harvard University - Department of Economics; National Bureau of Economic Research (NBER)
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)
London School of Economics
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, N22working papers series
Date posted: March 15, 2012
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