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The CAPM strikes back? An equilibrium model with disasters

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  • Bai, Hang
  • Hou, Kewei
  • Kung, Howard
  • Li, Erica X.N.
  • Zhang, Lu

Abstract

Embedding disasters into a general equilibrium model with heterogeneous firms induces strong nonlinearity in the pricing kernel, helping explain the empirical failure of the (consumption) CAPM. Our single-factor model reproduces the failure of the CAPM in explaining the value premium in finite samples without disasters and its relative success in samples with disasters. Due to beta measurement errors, the estimated beta-return relation is flat, consistent with the beta “anomaly,” even though the true beta-return relation is strongly positive. Finally, the consumption CAPM fails in simulations, even though a nonlinear model with the true pricing kernel holds exactly by construction.

Suggested Citation

  • Bai, Hang & Hou, Kewei & Kung, Howard & Li, Erica X.N. & Zhang, Lu, 2019. "The CAPM strikes back? An equilibrium model with disasters," Journal of Financial Economics, Elsevier, vol. 131(2), pages 269-298.
    • Handle: RePEc:eee:jfinec:v:131:y:2019:i:2:p:269-298
    DOI: 10.1016/j.jfineco.2018.08.009
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    More about this item

    Keywords

    CAPM; Rare disasters; Measurement errors; Consumption CAPM; General equilibrium;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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