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Time-varying risk components in the single-factor market model: an exact most powerful invariant test

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  • Philip Shively

Abstract

There is mounting evidence that stock prices have a time-varying predictable component. This paper tests for time-varying systematic risk, market compensation for systematic risk, and risk premiums in the single-factor market model to determine (1) whether the predictable stock-price component is due to time-varying risk premiums in an efficient market or an inefficient market with constant risk premiums, and (2) whether the time-varying risk premiums are due to time-varying systematic risk or time-varying market compensation for systematic risk. This paper applies an exact small-sample, pointwise most powerful invariant test to ten size and 12 industry portfolios. It finds consistent evidence of time variation in all three risk components over the full 35-year sample, but largely sporadic evidence of time variation over the five seven-year subsamples. Of the portfolios that show evidence of time-varying risk premiums, they are most likely the result of time-varying market compensation for systematic risk and not time-varying systematic risk.

Suggested Citation

  • Philip Shively, 2004. "Time-varying risk components in the single-factor market model: an exact most powerful invariant test," Applied Financial Economics, Taylor & Francis Journals, vol. 14(13), pages 945-952.
  • Handle: RePEc:taf:apfiec:v:14:y:2004:i:13:p:945-952
    DOI: 10.1080/0960310042000180817
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    1. Myung Jig Kim & Charles R. Nelson & Richard Startz, 1991. "Mean Reversion in Stock Prices? A Reappraisal of the Empirical Evidence," Review of Economic Studies, Oxford University Press, vol. 58(3), pages 515-528.
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    3. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
    4. Breeden, Douglas T & Gibbons, Michael R & Litzenberger, Robert H, 1989. " Empirical Tests of the Consumption-Oriented CAPM," Journal of Finance, American Finance Association, vol. 44(2), pages 231-262, June.
    5. Ferson, Wayne E & Korajczyk, Robert A, 1995. "Do Arbitrage Pricing Models Explain the Predictability of Stock Returns?," The Journal of Business, University of Chicago Press, vol. 68(3), pages 309-349, July.
    6. Poterba, James M. & Summers, Lawrence H., 1988. "Mean reversion in stock prices : Evidence and Implications," Journal of Financial Economics, Elsevier, vol. 22(1), pages 27-59, October.
    7. Ferson, Wayne E & Harvey, Campbell R, 1993. "The Risk and Predictability of International Equity Returns," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 527-566.
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