The CAPM Strikes Back? An Investment Model with Disasters

41 Pages Posted: 16 Mar 2015

See all articles by Hang Bai

Hang Bai

University of Connecticut - Department of Finance

Kewei Hou

Ohio State University (OSU) - Department of Finance

Howard Kung

London Business School; Centre for Economic Policy Research (CEPR)

Lu Zhang, 张橹

Ohio State University - Fisher College of Business; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: March 2015

Abstract

Value stocks are more exposed to disaster risk than growth stocks. Embedding disasters into an investment-based asset pricing model induces strong nonlinearity in the pricing kernel. Our single-factor model reproduces the failure of the CAPM in explaining the value premium in finite samples in which disasters are not materialized, and its relative success in samples in which disasters are materialized. The relation between pre-ranking market betas and average returns is flat in simulations, despite a strong positive relation between true market betas and expected returns. Evidence in the long U.S. sample from 1926 to 2014 lends support to the model’s key predictions.

Suggested Citation

Bai, Hang and Hou, Kewei and Kung, Howard and Zhang, Lu, The CAPM Strikes Back? An Investment Model with Disasters (March 2015). NBER Working Paper No. w21016. Available at SSRN: https://ssrn.com/abstract=2578844

Hang Bai (Contact Author)

University of Connecticut - Department of Finance ( email )

School of Business
2100 Hillside Road
Storrs, CT 06269
United States

Kewei Hou

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-0552 (Phone)
614-292-2418 (Fax)

Howard Kung

London Business School ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Lu Zhang

Ohio State University - Fisher College of Business ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
585-267-6250 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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