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

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  • Brennan, Michael
  • Wang, Ashley W
  • Xia, Yihong
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    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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    Bibliographic Info

    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 qt20r0j5t8.

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    Date of creation: 28 Mar 2003
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    Handle: RePEc:cdl:anderf:qt20r0j5t8

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    1. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    2. Gibbons, Michael R & Ross, Stephen A & Shanken, Jay, 1989. "A Test of the Efficiency of a Given Portfolio," Econometrica, Econometric Society, vol. 57(5), pages 1121-52, September.
    3. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
    4. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
    5. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
    6. John Y. Campbell & Luis M. Viceira, 1998. "Who Should Buy Long-Term Bonds?," NBER Working Papers 6801, National Bureau of Economic Research, Inc.
    7. Darrell Duffie & Rui Kan, 1996. "A Yield-Factor Model Of Interest Rates," Mathematical Finance, Wiley Blackwell, vol. 6(4), pages 379-406.
    8. Gabriel Perez-Quiros & Allan Timmermann, 2000. "Firm Size and Cyclical Variations in Stock Returns," Journal of Finance, American Finance Association, vol. 55(3), pages 1229-1262, 06.
    9. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
    10. Jagannathan, Ravi & Wang, Zhenyu, 1996. " The Conditional CAPM and the Cross-Section of Expected Returns," Journal of Finance, American Finance Association, vol. 51(1), pages 3-53, March.
    11. John Y. Campbell, 1992. "Intertemporal Asset Pricing Without Consumption Data," NBER Working Papers 3989, National Bureau of Economic Research, Inc.
    12. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
    13. Babbs, Simon H. & Nowman, K. Ben, 1999. "Kalman Filtering of Generalized Vasicek Term Structure Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(01), pages 115-130, March.
    14. Kandel, Shmuel & Stambaugh, Robert F, 1990. "Expectations and Volatility of Consumption and Asset Returns," Review of Financial Studies, Society for Financial Studies, vol. 3(2), pages 207-32.
    15. Kim, Tong Suk & Omberg, Edward, 1996. "Dynamic Nonmyopic Portfolio Behavior," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 141-61.
    16. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
    17. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    18. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
    19. Stambaugh, Robert F., 1988. "The information in forward rates : Implications for models of the term structure," Journal of Financial Economics, Elsevier, vol. 21(1), pages 41-70, May.
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    Cited by:
    1. Mele, Antonio, 2004. "General Properties of Rational Stock-Market Fluctuations," Economics Series 153, Institute for Advanced Studies.
    2. 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.
    3. 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.
    4. Munk, Claus & Sorensen, Carsten & Nygaard Vinther, Tina, 2004. "Dynamic asset allocation under mean-reverting returns, stochastic interest rates, and inflation uncertainty: Are popular recommendations consistent with rational behavior?," International Review of Economics & Finance, Elsevier, vol. 13(2), pages 141-166.

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