In the past two decades, financial economists have challenged the capital asset pricing model (CAPM) developed by Sharpe (1964) and Lintner (1965). In particular, there are three wellestablished CAPM-related anomalies: (1) the size premium (e.g., Basu, 1977 and Banz, 1981); (2) the value premium (e.g., Fama and French, 1992); and (3) the momentum profit (e.g., Jegadeesh and Titman, 1993). Some authors, e.g., Fama and French (1996) and Carhart (1997), argue that these anomalies reflect systematic risk and include them as additional risk factors in the empirical asset pricing models; others, however, attribute them to data mining or irrational pricing.
This paper attempts to provide some insight on this debate by investigating whether, as first pointed out by Merton (1973), the CAPM-related anomalies reflect a hedge demand for changes in investment opportunities. We first develop a discrete-time heteroskedastic intertemporal CAPM (ICAPM), which is a simple extension of Campbell’s (1993) model. In our model, risk factors include a stock market return and variables forecasting stock market returns or variance. Another innovation of the paper is the use of a new set of forecasting variables—the consumption-wealth ratio (e.g., Lettau and Ludvigson, 2001), realized stock market variance, and the stochastically detrended risk-free rate—as proxy for time-varying investment opportunities.
These variables have important advantages. First, they have significant out-of-sample predictive power for stock market returns and subsume the information content of the variables commonly used by the early authors (e.g., Guo, 2006). Second, these variables are also strong predictors of stock market volatility an important measure of investment opportunities in our ICAPM (e.g., Lettau and Ludvigson, 2002). Third, they are theoretically motivated (e.g., Guo, 2004 and Bernanke and Gertler, 1989).
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Time-Varying Risk Premia and the Cross Section of Stock Returns
