Linking Cross-Sectional and Aggregate Expected Returns
51 Pages Posted: 3 Nov 2014 Last revised: 22 Feb 2015
Date Written: February 8, 2015
We propose a one-state-variable ICAPM which rationalizes a large set of stock return anomalies, including size, value, and momentum. Differential covariance with news about future market discount rates drives observed cross-sectional patterns in expected returns. In response to discount-rate shocks, large, growth, and recent loser stocks outperform small, value, and winner stocks, respectively. Our interpretation is that increases in discount rates represent “bad” news, increasing investors’ marginal utility of wealth. Ignoring this state variable causes drastic underestimation of the equilibrium price of “level risk” in bond returns. The model augmented with a “level” factor jointly prices stocks and bonds.
Keywords: risk premium, CAPM, ICAPM, discount rates, hedging demand
JEL Classification: G12, G14
Suggested Citation: Suggested Citation