The Conditional CAPM Explains the Value Premium

41 Pages Posted: 18 Nov 2012 Last revised: 25 Mar 2014

See all articles by Turan G. Bali

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)

Date Written: March 2014

Abstract

This paper proposes alternative specifications of the conditional CAPM with dynamic conditional beta and tests the models' performance in explaining the value premium for the period 1963-2011. The conditional alphas on the value-minus-growth portfolio are estimated to be economically and statistically insignificant, indicating superior performance of the conditional CAPM in explaining the value premium. The results also show that the dynamic conditional covariances of book-to-market portfolios with default spread, dividend yield, and unemployment rate are significant predictors of future returns, implying that default risk, dividend and unemployment related shocks contain systematic risks rewarded in the stock market and they can be viewed as state variables proxying for consumption and investment opportunities. Hence, the superior returns to value stocks represent compensation for bearing the risk of unfavorable shifts in the investment opportunity set along the lines of Merton's (1973) ICAPM.

Keywords: Value Premium, Book-to-Market, Conditional CAPM, ICAPM, Dynamic Conditional Beta

JEL Classification: G12, G13, C51

Suggested Citation

Bali, Turan G. and Engle, Robert F., The Conditional CAPM Explains the Value Premium (March 2014). Georgetown McDonough School of Business Research Paper; Sloan Foundation Economics Research Paper. Available at SSRN: https://ssrn.com/abstract=2177321 or http://dx.doi.org/10.2139/ssrn.2177321

Turan G. Bali (Contact Author)

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Robert F. Engle

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

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New York University (NYU) - Department of Finance

Stern School of Business
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National Bureau of Economic Research (NBER)

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