Unemployment-based Capital Asset Pricing Model

Abstract

In this paper, we wish to examine how prospects of unemployment might change predictions of consumption based CAPM with regards to equity premium and term structure of interest. In particular, instead of agents having varied consumption growth, we study agents with probability of losing significant portion of their consumption. Thus, volatility of unemployment determines risk in the economy, rather than volatility of the consumption. Within framework of Epstein-Zin utility function, our model correctly predicts term structure premium and equity premium. In particular, the model predicts one-year risk-free rate of 1.71%, 30-year risk-free rate of 3.17% and equity rate of 7.33% given parameter of risk aversion of 1,2, EIS of 1,54, and time discount factor of 0.9578. Additionally, we study importance of third moments in our model and discover new pricing factor that is missing in current skewness models. Empirical tests under various conditions confirm statistical significance of our factor. Finally, we utilize our model to predict market changes based on shifts in term structure and then empirically verify model predictions. This paper demonstrates that standard C-based CAPM is more than enough to predict observed term structure and equity premium and no model modification is required if proper consumption variation statistics is used.

Keywords: Equity premium, equity premium puzzle, risk free rate puzzle, term structure of interest, CCAPM, Epstein-Zin utility function, valuation, price of risk, co-skewness

JEL Classification: G11, G12, M21