Equity Return Predictability with the ICAPM

Abstract

This paper highlights the performance of the ICAPM in predicting future asset returns. Consistent with the ICAPM, the relation between future asset returns and betas is positive and statistically significant when future market returns are expected to be high. In addition, the sum of an intertemporal hedging component and beta times the expected market return predicts asset returns out-of-sample, as predicted by the ICAPM. Consequently, timing strategies exploiting the predictive power of the ICAPM have Sharpe ratios that are up to twice those obtained by buying and holding and statistically significant abnormal returns (alphas) of about 5% per annum.

Keywords: return predictability, intertemporal capital asset pricing model, investment strategies

JEL Classification: D53, G11, G12