THE SEARCH OF AN ECONOMIC STATE VARIABLE FOR INTER-TEMPORAL ASSET PRICING: EVIDENCE FROM JAKARTA STOCK EXCHANGE
Universitas Kristen Duta Wacana
Three-factor capital asset pricing model (CAPM)-beta, size, and book-to-market equity appears to dominate most other variables in the empirical explanation of cross-sectional returns. This study attempts to find a link between the prominent three-factor CAPM and the dynamic feature of inter-temporal CAPM by searching a simple ex-ante economic state variable. Using data from Jakarta Stock Exchange, this study finds that the three-factor CAPM holds in the full sample. After separating the samples into stable and unstable economic conditions, the result indicates that the risk premiums associated with the three-factor CAPM do vary, but the magnitudes of the variation cannot be observed due to some statistical problems. However, an ex-ante economic state variable, growth of change in money supply, proposed in this study fails to capture the time varying risk premiums attached in the three-factor CAPM.
1 Fakultas Ekonomi UKDW, Jl. Dr. Wahidin 5-21 Jogjakarta 55224.Telpon: (0274) 563929 pswt. 221.
The relationship between risk and return has been the focus of recent capital market research. Numerous papers have derived various version of the capital asset pricing model (CAPM), ranging from single-factor CAPM (Sharpe-Lintner and Black versions), conditional CAPM (Engle, 1982 and Bollerslev, 1986), Arbitrage Pricing Theory (Ross, 1976, Huberman, 1982, Chamberlain and Rothschild, 1983, Lehman and Modest, 1988), three-factor CAPM (Fama and French, 1992, 1995; Chan, Jagedeesh, and Lakonishok, 1995), intertemporal CAPM (Merton, 1973, and Breeden’s, 1979), to international CAPM (Solnik, 1974, Korajczyk and Viallet, 1989). The role of beta in explaining the cross-sectional variation in stock returns are well documented. In fact, beta has a rich theoretical foundation but lacks empirical support. Two variables found to be prominent in explaining the cross-sectional variation of return are size, as measured by market value of equity, and book-to-market equity. These two variables combined with beta (three-factor CAPM) appear to dominate most other variables in the empirical explanation of cross-sectional returns.
The purpose of this study is to find a link between the prominent three-factor CAPM and the dynamic feature of inter-temporal CAPM. In a dynamic economy, it is often believed that if an investor anticipate information shifts, he will adjust his portfolio to hedge these shifts. To capture the dynamic hedging effect, Merton (1973) develops a continuous-time asset pricing model which explicitly takes into account hedging demand. In contrast to the APT framework (employing undefined numbers of state variables), there are only two factors which are theoretically derived from Merton’s model (1973): a market factor and a hedging factor. However, an empirical investigation is not easy to implement for the continuous-time model.
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