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Dynamic Present Values and the Intertemporal CAPM

44 Pages Posted: 12 Aug 2011 Last revised: 14 May 2014

Bjorn Eraker

University of Wisconsin - Madison - Department of Finance, Investment and Banking

Wenyu Wang

Indiana University - Kelley School of Business - Department of Finance

Date Written: October 26, 2011

Abstract

A common method for constructing equilibrium price processes in finance is to assume a price process, and then solve for the time-varying expected return. We argue that this method is potentially inconsistent with present value computations. In particular, this approach may imply that the assumed dynamic equation for risky asset prices misses certain important terms that allow the price to adjust to changes in expected returns. We derive an alternative version of the Intertemporal CAPM based explicitly on present value computation with a strictly exogenous lump sum cash flow. Our model is derived without any a priori assumptions about the structure of the equilibrium price process. An essential feature of our model is that prices respond endogenously to the shocks to systematic risks such as market volatility shocks. Unlike other present value models, prices in our general equilibrium framework can be computed without approximations.

Keywords: CAPM, Conditional CAPM, ICAPM, Dynamic Consistency, Present Value, Dynamic Equilibrium

JEL Classification: G1, G12

Suggested Citation

Eraker, Bjorn and Wang, Wenyu, Dynamic Present Values and the Intertemporal CAPM (October 26, 2011). Available at SSRN: https://ssrn.com/abstract=1908910 or http://dx.doi.org/10.2139/ssrn.1908910

Bjorn Eraker (Contact Author)

University of Wisconsin - Madison - Department of Finance, Investment and Banking ( email )

975 University Avenue
Madison, WI 53706
United States

Wenyu Wang

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States

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