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Time-varying state variable risk premia in the ICAPM

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  • Barroso, Pedro
  • Boons, Martijn
  • Karehnke, Paul

Abstract

We find that the relation between state variables, such as the t-bill rate and term spread, and consumption growth is time-varying. In the cross-section of U.S. stocks, risk premia for exposure to state variables vary over time accordingly. When a state variable predicts consumption strongly relative to its own history, its annualized risk premium increases by 6% (0.4 in Sharpe ratio). This effect implies that risk premia can switch signs and are increasing in the conditional variance of the state variable. These common drivers of time-varying risk premia are consistent with the Intertemporal CAPM. Benchmark factors contain the same conditional expected return effects as state variable risk premia.

Suggested Citation

  • Barroso, Pedro & Boons, Martijn & Karehnke, Paul, 2021. "Time-varying state variable risk premia in the ICAPM," Journal of Financial Economics, Elsevier, vol. 139(2), pages 428-451.
    • Handle: RePEc:eee:jfinec:v:139:y:2021:i:2:p:428-451
    DOI: 10.1016/j.jfineco.2020.07.016
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    3. Fabian Hollstein & Marcel Prokopczuk, 2023. "Managing the Market Portfolio," Management Science, INFORMS, vol. 69(6), pages 3675-3696, June.

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    Keywords

    Conditional asset pricing models; State variables; Intertemporal CAPM; Consumption predictability; Time-varying equity risk premia;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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