Intertemporal CAPM and the Cross-Section of Stock Returns

56 Pages Posted: 3 Mar 2002

See all articles by Joseph Chen

Joseph Chen

University of California, Davis - Graduate School of Management

Date Written: May 2002

Abstract

This paper examines whether the historically high returns associated with the size effect, the book-to-market effect, and the momentum effect can be explained within an asset pricing framework suggested by Merton's (1973) Intertemporal Capital Asset Pricing Model. Controlling for the market, an asset may earn a risk premium if it performs poorly when the prospects for the future turn sour. I develop a model with time-varying expected market returns and time-varying market volatilities to reflect thechanges in the investment opportunity set of the economy. Campbell's (1993, 1996) technique of substituting out aggregate consumption delivers two key insights.An underlying mechanism is that in the absence of frictions,the aggregate budget constraint restricts variations in market returns to affect aggregate consumption at some horizon. Hence the first insight is that if a factor reflects the changes in the investment opportunity set, its risk premium should be linked to the amount of information that it conveys about the future. The second insight is that the risk premia across factors should be linked to each other through the willingness of investors tobear risk. I test whether the returns associated with the size effect, the book-to-market effect, and the momentum effect are consistent with these restrictions.This model is estimated using a multivariate VAR-GARCH model with non-Gaussian innovations. The estimates suggest that the historical returns on thebook-to-market effect and the momentum effect are too high to be explained as compensation for exposures to adversechanges in the investment opportunity set.

Suggested Citation

Chen, Joseph S., Intertemporal CAPM and the Cross-Section of Stock Returns (May 2002). EFA 2002 Berlin Meetings Discussion Paper. Available at SSRN: https://ssrn.com/abstract=301918 or http://dx.doi.org/10.2139/ssrn.301918

Joseph S. Chen (Contact Author)

University of California, Davis - Graduate School of Management ( email )

One Shields Avenue
Davis, CA 95616
United States
(530) 752-7155 (Phone)
(530) 752-2924 (Fax)

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