A Cross Section of Equity Returns: The No-Arbitrage Test

Pongrapeeporn Abhakorn (), Peter N Smith () and Michael R. Wickens

Discussion Papers from Department of Economics, University of York

Abstract: We propose a new test based on the no-arbitrage condition that compares cross-sectional variation in equity returns to the cross-sectional variation in their conditional covariance with the discount factors. Using the multivariate generalized heteroskedasticity in mean model (MGM) to estimate the 25 portfolios formed on size and book-to-market ratio, together with each with its own arbitrage condition, we find that the no-arbitrage test rejects the consumption-based capital asset pricing model (C-CAPM). Although the conditional covariances of returns with consumption exhibit negative variation across size, they do not vary across the book-to-market ratio. Thus, the C-CAPM can capture size effect, but not value effect. Allowing the coefficients on the consumption covariances to be different largely improves the fit of the C-CAPM, however. The value effect appears to be associated with book-to-market ratio as well as size. Book-to-market ratio separately does not generate information about average returns that cannot be explained by the C-CAPM.

Keywords: Risk Premium; Equity Return; Stochastic Discount Factor; No-arbitrage Condition (search for similar items in EconPapers)
JEL-codes: G12 G14 C32 E44 (search for similar items in EconPapers)
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