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Time-varying risk components in the single-factor market model: an exact most powerful invariant test

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  • Philip Shively
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    Abstract

    There is mounting evidence that stock prices have a time-varying predictable component. This paper tests for time-varying systematic risk, market compensation for systematic risk, and risk premiums in the single-factor market model to determine (1) whether the predictable stock-price component is due to time-varying risk premiums in an efficient market or an inefficient market with constant risk premiums, and (2) whether the time-varying risk premiums are due to time-varying systematic risk or time-varying market compensation for systematic risk. This paper applies an exact small-sample, pointwise most powerful invariant test to ten size and 12 industry portfolios. It finds consistent evidence of time variation in all three risk components over the full 35-year sample, but largely sporadic evidence of time variation over the five seven-year subsamples. Of the portfolios that show evidence of time-varying risk premiums, they are most likely the result of time-varying market compensation for systematic risk and not time-varying systematic risk.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/0960310042000180817
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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal Applied Financial Economics.

    Volume (Year): 14 (2004)
    Issue (Month): 13 ()
    Pages: 945-952

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    Handle: RePEc:taf:apfiec:v:14:y:2004:i:13:p:945-952

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    Web page: http://www.tandfonline.com/RAFE20

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    1. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
    2. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
    3. Ferson, Wayne E & Harvey, Campbell R, 1993. "The Risk and Predictability of International Equity Returns," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 527-66.
    4. James M. Poterba & Lawrence H. Summers, 1989. "Mean Reversion in Stock Prices: Evidence and Implications," NBER Working Papers 2343, National Bureau of Economic Research, Inc.
    5. Breeden, Douglas T & Gibbons, Michael R & Litzenberger, Robert H, 1989. " Empirical Tests of the Consumption-Oriented CAPM," Journal of Finance, American Finance Association, vol. 44(2), pages 231-62, June.
    6. Ferson, Wayne E & Korajczyk, Robert A, 1995. "Do Arbitrage Pricing Models Explain the Predictability of Stock Returns?," The Journal of Business, University of Chicago Press, vol. 68(3), pages 309-49, July.
    7. Myung Jig Kim & Charles R. Nelson & Richard Startz, 1991. "Mean Reversion in Stock Prices? A Reappraisal of the Empirical Evidence," NBER Working Papers 2795, National Bureau of Economic Research, Inc.
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