59 Pages Posted: 31 Jan 2000
Date Written: November 1999
This paper explores the ability of theoretically based asset pricing models such as the CAPM and the consumption CAPM-referred to jointly as the (C)CAPM-to explain the cross-section of average stock returns. Unlike many previous empirical tests of the (C)CAPM, we specify the pricing kernel as a conditional linear factor model, as would be expected if risk premia vary over time. Central to our approach is the use of a conditioning variable which proxies for fluctuations in the log consumption-aggregate wealth ratio and is likely to be important for summarizing conditional expectations of excess returns. We demonstrate that such conditional factor models are able to explain a substantial fraction of the cross-sectional variation in portfolio returns. These models perform much better than unconditional (C)CAPM specifications, and about as well as the three-factor Fama-French model on portfolios sorted by size and book-to-market ratios. This specification of the linear conditional consumption CAPM, using aggregate consumption data, is able to account for the difference in returns between low book-to-market and high book-to-market firms and exhibits little evidence of residual size or book-to-market effects.
JEL Classification: E21, G10
Suggested Citation: Suggested Citation
Lettau, Martin and Ludvigson, Sydney C., Resurrecting the (C)CAPM: A Cross-Sectional Test when Risk Premia wre Time-Varying (November 1999). Eleventh Annual Utah Winter Conference; AFA 2001 New Orleans; FRB of New York Staff Reports, No. 93. Available at SSRN: https://ssrn.com/abstract=203369 or http://dx.doi.org/10.2139/ssrn.203369
By Owen Lamont