W-MPS Risk Aversion and the Shadow CAPM: Theory and Empirical Evidence
48 Pages Posted: 21 Sep 2016
Date Written: August 1, 2015
Abstract
This paper presents the shadow Capital Asset Pricing Model (CAPM) of Ma (2011a) as an intertemporal equilibrium asset pricing model, and tests it empirically. In contrast to the classical CAPM - a single factor model based on a strong behavioral or distributional assumption, the shadow CAPM can be represented as a two factor model, and only requires a modest behavioral assumption of weak form mean-preserving spread (w-MPS) risk aversion. The empirical tests provide support in favor of the shadow CAPM over the classical CAPM, the Consumption CAPM, or the Epstein and Zin (1991) model. Moreover, the shadow CAPM provides a consistent explanation for the cross-sectional variations of expected returns on the stocks and for the time-varying equity premium.
Keywords: equity premium, w-MPS risk aversion, recursive utility, shadow price
JEL Classification: G12, G11
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