Explaining the Failure of the Unconditional CAPM with the Conditional CAPM
56 Pages Posted: 2 Apr 2019 Last revised: 9 Jan 2021
Date Written: January 8, 2021
When the cost of hedging is nil, the conditional CAPM holds (Merton, 1973). We empirically test the conditional CAPM by regressing asset returns onto the product of their conditional betas and market returns. Estimated intercepts are not statistically different from zero, implying that the conditional CAPM successfully explains the conditional level of asset returns. Yet, unconditional betas do not explain the cross-section of average asset returns; the unconditional CAPM fails. We show why and how the success of the conditional CAPM actually explains the failure of the unconditional CAPM, thereby rationalizing the coexistence of these two intriguing results.
Keywords: Capital asset pricing model, cross-section of stock returns
JEL Classification: D53, G11, G12
Suggested Citation: Suggested Citation