What Do Hedge Portfolios Hedge? Evidence From an Intertemporal CAPM in the Presence of Background Wealth

Abstract

Using return decomposition and a new approach to differentiate between traded and non-traded background risk, our paper proposes a risk-based interpretation for the hedge portfolios in the five-factor model of Fama and French (2015). Specifically, our results suggest that non-traded background risks, most notably human capital and housing risk, are of special hedging concern to investors and can be insured by selling short those hedge portfolios. Furthermore, a news-based four-factor model including cash-flow and discount-rate news on background wealth along with both news components of traded wealth, prices stocks at least as well as the five-factor model of Fama and French (2015). Overall, our results highlight the importance of accounting for background wealth in explaining the cross-section of stock returns.

Keywords: Asset Pricing, Hedge Portfolios, Expected Returns, Background Wealth, ICAPM, Return Decomposition

JEL Classification: G11, G12