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Estimation and Test of a Simple Model of Intertemporal Capital Asset Pricing
Author(s) -
Brennan Michael J.,
Wang Ashley W.,
Xia Yihong
Publication year - 2004
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.2004.00678.x
Subject(s) - capital asset pricing model , economics , sharpe ratio , risk premium , econometrics , treasury , consumption based capital asset pricing model , bond , valuation (finance) , investment (military) , equity premium puzzle , financial economics , portfolio , finance , politics , political science , law , history , archaeology
A simple valuation model with time‐varying investment opportunities is developed and estimated. The model assumes that the investment opportunity set is completely described by the real interest rate and the maximum Sharpe ratio, which follow correlated Ornstein–Uhlenbeck processes. The model parameters and time series of the state variables are estimated using U.S. Treasury bond yields and expected inflation from January 1952 to December 2000, and as predicted, the estimated maximum Sharpe ratio is related to the equity premium. In cross‐sectional asset‐pricing tests, both state variables have significant risk premia, which is consistent with Merton's ICAPM.