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"Shooting" the CAPM

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  • Lu Zhang

    (The Ohio State University)

  • Howard Kung

    (University of British Columbia)

  • Hang Bai

    (The Ohio State University)

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    Abstract

    We provide a disaster-based explanation for the failure of the CAPM in the post-Compustat sample as well as its success to explain the value premium in the long sample that includes the Great Depression. In an investment-based asset pricing model embedded with rare disasters, value stocks are more sensitive to disaster shocks than growth stocks. More important, disasters introduce strong nonlinearities in the relation between the pricing kernel and the return on wealth. The nonlinearities allow the model to explain the failure of the CAPM in samples in which disasters are not materialized. However, the CAPM explains the value premium in samples with disasters in the model, consistent with the data.

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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2013 Meeting Papers with number 905.

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    Date of creation: 2013
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    Handle: RePEc:red:sed013:905

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    References

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    1. Jonathan Lewellen & Stefan Nagel, 2003. "The Conditional CAPM does not Explain Asset-Pricing Anamolies," NBER Working Papers 9974, National Bureau of Economic Research, Inc.
    2. Petkova, Ralitsa & Zhang, Lu, 2005. "Is value riskier than growth?," Journal of Financial Economics, Elsevier, vol. 78(1), pages 187-202, October.
    3. Leonid Kogan & Dimitris Papanikolaou, 2012. "A Theory of Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks," NBER Working Papers 17975, National Bureau of Economic Research, Inc.
    4. Francois Gourio, 2009. "Disaster risk and business cycles," 2009 Meeting Papers 1176, Society for Economic Dynamics.
    5. Robert J. Barro, 2007. "Rare Disasters, Asset Prices, and Welfare Costs," NBER Working Papers 13690, National Bureau of Economic Research, Inc.
    6. Eugene F. Fama & Kenneth R. French, 2006. "The Value Premium and the CAPM," Journal of Finance, American Finance Association, vol. 61(5), pages 2163-2185, October.
    7. Ian Martin, 2010. "Consumption-Based Asset Pricing with Higher Cumulants," NBER Working Papers 16153, National Bureau of Economic Research, Inc.
    8. Lu Zhang, 2005. "The Value Premium," Journal of Finance, American Finance Association, vol. 60(1), pages 67-103, 02.
    9. Belo, Frederico & Lin, Xiaoji, 2012. "Labor Heterogeneity and Asset Prices: The Importance of Skilled Labor," Working Paper Series 2012-25, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    10. John H. Cochrane, 2011. "Presidential Address: Discount Rates," Journal of Finance, American Finance Association, vol. 66(4), pages 1047-1108, 08.
    11. John H. Cochrane, 2011. "Discount Rates," NBER Working Papers 16972, National Bureau of Economic Research, Inc.
    12. Santiago Bazdrech & Frederico Belo & Xiaoji Lin, 2008. "Labor hiring, investment and stock return predictability in the cross section," LSE Research Online Documents on Economics 24418, London School of Economics and Political Science, LSE Library.
    13. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
    14. Lin, Xiaoji & Zhang, Lu, 2013. "The investment manifesto," Journal of Monetary Economics, Elsevier, vol. 60(3), pages 351-366.
    15. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
    16. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
    17. Andrew Ang & Joseph Chen, 2005. "CAPM Over the Long Run: 1926-2001," NBER Working Papers 11903, National Bureau of Economic Research, Inc.
    18. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
    19. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
    20. Georg Kaltenbrunner & Lars A. Lochstoer, 2010. "Long-Run Risk through Consumption Smoothing," Review of Financial Studies, Society for Financial Studies, vol. 23(8), pages 3190-3224, August.
    21. Ai, Hengjie & Kiku, Dana, 2013. "Growth to value: Option exercise and the cross section of equity returns," Journal of Financial Economics, Elsevier, vol. 107(2), pages 325-349.
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