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Resurrecting the (C)CAPM: a cross-sectional test when risk premia are time-varying

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Martin Lettau
Sydney Ludvigson

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Abstract

This paper explores the ability of theoretically based asset pricing models such as the CAPM and the consumption CAPM-referred to jointly as the (C)CAPM - to explain the cross-section of average stock returns. Unlike many previous empirical tests of the (C)CAPM, we specify the pricing kernel as a conditional linear factor model, as would be expected if risk premia vary over time. Central to our approach is the use of a conditioning variable which proxies for fluctuations in the log consumption-aggregate wealth ratio and is likely to be important for summarizing conditional expectations of excess returns. We demonstrate that such conditional factor models are able to explain a substantial fraction of the cross-sectional variation in portfolio returns. These models perform much better than unconditional (C)CAPM specifications, and about as well as the three-factor Fama-French model on portfolios sorted by size and book-to-market ratios. This specification of the linear conditional consumption CAPM, using aggregate consumption data, is able to account for the difference in returns between low book-to-market and high book-to-market firms and exhibits little evidence of residual size or book-to-market effects.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 93.

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Date of creation: 1999
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Handle: RePEc:fip:fednsr:93

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Keywords: Rate of return Asset pricing

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