Estimation and Test of a Simple Model of Intertemporal Capital Asset Pricing

Abstract

A simple valuation model that allows for time variation in investment opportunities is developed and estimated. The model assumes that the investment opportunity set is completely described by two state variables, the real interest rate and the maximum Sharpe ratio, which follow correlated Ornstein-Uhlenbeck processes. The model parameters and time series of the state variables are estimated using data on US Treasury bond yields and inflation for the period January 1952 to December 2000. The estimated state variables are shown to be related to the equity premium and to the level of stock prices as measured by the dividend yield. Innovations in the estimated state variables are shown to be related to the returns on the Fama-French arbitrage portfolios, HML and SMB, providing a possible explanation for the risk premia on these portfolios. When tracking portfolios for the state variable innovations are constructed using returns on 6 size and book-to market equity sorted portfolios, the tracking portfolios explain the risk premia on HML and SMB, and these state variable tracking portfolios perform about as well as HML and SMB in explaining the cross-section of returns on the 25 size and book-to market equity sorted value weighted portfolios. An additional test of the ICAPM using returns on 30 industrial portfolios does not reject the model while the CAPM and the Fama-French 3 factor model are rejected using the same data.

Earnings Announcements and Systematic Risk

“…Our results are consistent with the hypothesis of Campbell (1993) and Campbell and Vuolteenaho (2004) that cash flow risk should earn higher compensation than discount rate risk (see also Brennan, Wang, and Xia (2004)). Longterm investors should primarily care about cash flow risk, as they can "ride out" changes in discount rates.…”

Can An ‘Estimation Factor’ Help Explain Cross‐Sectional Returns?

“…That is, there is a linear relation between changes in the representative agent's estimate and changes in the interest rate. This relates our paper to Brennan et al (2004) who estimate an ICAPM model where changes in the real interest rate and the maximum Sharpe ratio are found to have significant risk premia.…”

“…Interestingly, our paper is related to Brennan et al (2004) since, in our formal model, there is a linear relation between changes in the interest rate and changes in the representative agent's estimate. Brennan et al (2004) estimate an ICAPM model where changes in the real interest rate and the maximum Sharpe ratio are found to have significant risk premia.…”

Multifactor Models and their Consistency with the ICAPM: Evidence from the European Stock Market

“…Sixth, we exclude the market excess return from the set of testing assets. Seventh, we estimate all multifactor models in expected return-beta representation with the time-series/cross-sectional regression approach employed by, for example, Brennan et al (2004) and Cochrane (2005, Ch. 12.2).…”

“…In particular, many factor models are explicitly justified by their authors as empirical applications of the ICAPM (e.g. Brennan et al, 2004;Campbell and Vuolteenaho, 2004;Hahn and Lee, 2006;Petkova, 2006). These models include risk factors in addition to the excess market return that are innovations in economic variables (e.g.…”