Dynamic Present Values and the Intertemporal CAPM
44 Pages Posted: 12 Aug 2011 Last revised: 14 May 2014
Date Written: October 26, 2011
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: Suggested Citation