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The Conditional CAPM, Cross-Section Returns and Stochastic Volatility

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  • Fung, Ka Wai Terence
  • Lau, Chi Keung Marco
  • Chan, Kwok Ho

Abstract

Bansal and Yaron (2004) demonstrate, by calibration, that the Consumption-Based Capital Asset Pricing Model (CCAPM) can be rescued by assuming that consumption growth rate follows a stochastic volatility model. They show that the conditional equity premium is a linear function of conditional consumption and market return volatilities, which can be estimated handily by various Generalized Autoregressive Conditonal Heterskedasticity (GARCH) and Stochastic Volatility (SV) models.We find that conditional consumption and market volatilities are capable of explaining cross-sectional return differences. The Exponential GARCH (EGARCH) volatility can explain up to 55% variation of return and the EGARCH model augmented with (cay) ̂ -a cointegrating factor of consumption, labor income and asset wealth growth- greatly enhance model performance. We proceed to test another hypothesis: if Bansal and Yaron estimator is an unbiased estimator of true conditional equity premium, then the instrumental variables for estimating conditional equity premium should no longer be significant.We demonstrate that once the theoretical conditional risk premium is added to the model, it renders all instrumental variables redundant. Also, the model prediction is consistent with observed declining equity premium.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 52469.

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Date of creation: 2013
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Handle: RePEc:pra:mprapa:52469

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Related research

Keywords: Financial Economics; Macroeconomics and Monetary Economics; Equity Premium Puzzle; Fama-French Model;

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References

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Cited by:
  1. Fung, Ka Wai Terence & Demir, Ender & Zhou, Lu, 2014. "Capital Asset Pricing Model and Stochastic Volatility: A Case study of India," MPRA Paper 56180, University Library of Munich, Germany.

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