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

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Author Info
Michael Brennan (Anderson School of Management)
Ashley Wang (Ph.D Candidate at Anderson School of Management)
Yihong Xia (The Wharton School)
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 expected in- flation for the period January 1952 to December 2000, and, as predicted, the estimated maximum Sharpe ratio is shown to be related to the equity premium. In cross-sectional asset pricing tests using the 25 Fama-French size and book-to-market portfolios, both state variables are found to have significant risk premia, which is consistent with the ICAPM of Merton (1973). In contrast to the CAPM and the Fama-French 3-factor model, the simple ICAPM is not rejected by cross-sectional tests using the 25 Fama-French size and B/M sorted portfolios. Returns on the 30 industrial portfolios do not discriminate clearly between the three models. When both sets of portfolios are included as test assets all three models are rejected, but the estimated risk premia for both ICAPM state variables are significant while those associated with the Fama-French arbitrage portfolios are insignificant.

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Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number 1011.

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Date of creation: 28 Mar 2003
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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Günter Franke & Erik Lüders, 2005. "Return Predictability and Stock Market Crashes in a Simple Rational Expectations Model," CoFE Discussion Paper 05-05, Center of Finance and Econometrics, University of Konstanz. [Downloadable!]
  2. Hui Guo & Robert Savickas, 2003. "On the cross section of conditionally expected stock returns," Working Papers 2003-043, Federal Reserve Bank of St. Louis. [Downloadable!]
  3. Günter Franke & Erik Lüders, 2006. "Return Predictability and Stock Market Crashes in a Simple Rational Expectations Model¤," CoFE Discussion Paper 06-05, Center of Finance and Econometrics, University of Konstanz. [Downloadable!]
  4. Mele, Antonio, 2004. "General Properties of Rational Stock-Market Fluctuations," Economics Series 153, Institute for Advanced Studies. [Downloadable!]
    Other versions:
  5. Lettau, Martin & Wachter, Jessica, 2005. "Why is Long-Horizon Equity Less Risky? A Duration-based Explanation of the Value Premium," CEPR Discussion Papers 4921, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
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