A Conditional Multi-Asset Intertemporal CAPM with Switching Prices of Risk
72 Pages Posted: 21 Nov 2000
Date Written: July 2000
This paper tests the conditional multi-asset Intertemporal CAPM of Merton (1973). When a single-asset static or Intertemporal CAPM is estimated, the risk-return relation is weak. Inclusion of additional assets inceases the power and efficiency of the test, making the price of market risk positive and significant. The prices of market and intertemporal risk are allowed to vary over time thanks to the regime switching model of Hamilton (1988, 1989, 1990, 1994). Two regimes are identified, one in which the price of market risk is high and the price of intertemporal risk is low, and one in which the reverse occurs, i.e. the first price is high and the second low. This can be interpreted as a switch in investors' preferences whose degree of risk aversion increases in correspondence to or after financial turmoil. Moreover, while stocks appear to be good hedges against business cycle downturns, fixed income securities do not.
Keywords: Intertemporal CAPM, GARCH-in-mean, regime shifts
JEL Classification: C32; C53; E32; G12.
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