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

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Author Info
Michael J. Brennan
Ashley W. Wang
Yihong Xia
Abstract

A simple valuation model with time-varying investment opportunities is developed and estimated. The model assumes that the investment opportunity set is completely described by 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 U.S. Treasury bond yields and expected inflation from January 1952 to December 2000, and as predicted, the estimated maximum Sharpe ratio is related to the equity premium. In cross-sectional asset-pricing tests, both state variables have significant risk premia, which is consistent with Merton's ICAPM. Copyright 2004 by The American Finance Association.

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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 59 (2004)
Issue (Month): 4 (08)
Pages: 1743-1776
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Handle: RePEc:bla:jfinan:v:59:y:2004:i:4:p:1743-1776

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