The CAPM Strikes Back? An Equilibrium Model with Disasters

64 Pages Posted: 7 Mar 2018

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)

Erica X. N. Li

Cheung Kong Graduate School of Business

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: February 28, 2018

Abstract

Embedding disasters into a general equilibrium model with heterogeneous firms induces strong nonlinearity in the pricing kernel, helping explain the empirical failure of the (consumption) CAPM. Our single-factor model reproduces the failure of the CAPM in explaining the value premium in finite samples without disasters, and its relative success in samples with disasters. Due to beta measurement errors, the estimated beta-return relation is flat, consistent with the beta “anomaly,” even though the true beta-return relation is strongly positive. Finally, the consumption CAPM fails in simulations, even though a nonlinear model with the true pricing kernel holds exactly by construction.

Keywords: The CAPM, Rare Disasters, Measurement Errors, The Consumption CAPM, General Equilibrium, Approximate Aggregation

JEL Classification: G12, G14

Suggested Citation

Bai, Hang and Hou, Kewei and Kung, Howard and Li, Erica X. N. and Zhang, Lu, The CAPM Strikes Back? An Equilibrium Model with Disasters (February 28, 2018). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=3132048

Hang Bai

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

Erica X. N. Li

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Lu Zhang (Contact Author)

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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