Can Stochastic Discount Factor Models Explain the Cross Section of Equity Returns?

TY - JOUR

T1 - Can Stochastic Discount Factor Models Explain the Cross Section of Equity Returns?

AU - Abhakorn, Pongrapeeporn

AU - Smith, Peter Nigel

AU - Wickens, Mike

N1 - © 2016 Elsevier Inc. All rights reserved. This is an author-produced version of the published paper. Uploaded in accordance with the publisher’s self-archiving policy.

PY - 2016/1

Y1 - 2016/1

N2 - We propose a multivariate test of the capital asset pricing model (C-CAPM) of the cross-sectional variation in equity returns in which we compare cross-sectional variation in equity returns to the cross-sectional variation in their conditional covariance with stochastic discount factors. We use a multivariate generalized heteroskedasticity in mean model to estimate 25 portfolios that are formed on size and the book-to-market ratio. Each portfolio is allowed to have its own no-arbitrage condition. We find that although the conditional covariances of returns with consumption exhibit negative variation across size, they do not vary across the book-to-market ratio. Thus, C-CAPM can capture the size effect, but not the value effect. The fit is, however, improved by allowing the coefficients on the consumption covariances to be different. The value effect appears to be associated with the book-to-market ratio as well as size. On its own the book-to-market ratio does not generate additional information about average returns to C-CAPM. A possible explanation for these findings is that both small and low book-to-market ratio firms are expected to have higher rates of growth.

AB - We propose a multivariate test of the capital asset pricing model (C-CAPM) of the cross-sectional variation in equity returns in which we compare cross-sectional variation in equity returns to the cross-sectional variation in their conditional covariance with stochastic discount factors. We use a multivariate generalized heteroskedasticity in mean model to estimate 25 portfolios that are formed on size and the book-to-market ratio. Each portfolio is allowed to have its own no-arbitrage condition. We find that although the conditional covariances of returns with consumption exhibit negative variation across size, they do not vary across the book-to-market ratio. Thus, C-CAPM can capture the size effect, but not the value effect. The fit is, however, improved by allowing the coefficients on the consumption covariances to be different. The value effect appears to be associated with the book-to-market ratio as well as size. On its own the book-to-market ratio does not generate additional information about average returns to C-CAPM. A possible explanation for these findings is that both small and low book-to-market ratio firms are expected to have higher rates of growth.

KW - Risk Premium; Equity Return; Stochastic Discount Factor; No-arbitrage

KW - Risk premium

KW - No-arbitrage condition

KW - Equity return

KW - Stochastic discount factor

UR - http://www.scopus.com/inward/record.url?scp=84957438582&partnerID=8YFLogxK

U2 - 10.1016/j.rfe.2016.01.001

DO - 10.1016/j.rfe.2016.01.001

M3 - Article

SN - 1058-3300

VL - 28

SP - 56

EP - 68

JO - Review of Financial Economics

JF - Review of Financial Economics

ER -