Conditional Risk

Abstract

We show theoretically that the required compensation for time-varying betas in the CAPM can be estimated by a precisely defined conditional-risk factor, which can be used in factor regressions. Both in the U.S. and global sample covering 23 countries, all major equity risk factors load on our conditional-risk factor, meaning that their market betas vary over time and that this variation explains part of their average returns. Studying the economic drivers of these results, we find evidence that this conditional risk arises from variation in discount rate betas (not cash flow betas) due to the endogenous effects of arbitrage trading.

Keywords: Asset Pricing, Conditional CAPM, Factor Models, Time-Varying Discount Rates

JEL Classification: G10, G12