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Investigating Icapm with Dynamic Conditional Correlations

67 Pages Posted: 13 Nov 2008  

Turan G. Bali

Georgetown University - Robert Emmett McDonough School of Business

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics; New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

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Date Written: 2007

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

Suggested Citation

Bali, Turan G. and Engle, Robert F., Investigating Icapm with Dynamic Conditional Correlations (2007). NYU Working Paper No. FIN-07-051. Available at SSRN: https://ssrn.com/abstract=1300783

Turan G. Bali (Contact Author)

Georgetown University - Robert Emmett McDonough School of Business ( email )

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Washington, DC 20057
United States
(202) 687-5388 (Phone)
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HOME PAGE: http://msbonline.georgetown.edu/faculty-research/msf-faculty/turan-bali

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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