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An inflation-based ICAPM in China

Han Zhang

Pacific-Basin Finance Journal, 2021, vol. 68, issue C

Abstract: There is a consensus regarding the weak link between China's stock market and its macro-economy. In contrast, this paper shows that inflation has a strong pricing ability for China's stock returns. We develop a two-factor intertemporal capital asset pricing model (ICAPM) of Merton (1973), in which inflation is a state variable. The theoretical results show that the marginal wealth value is high, when the economy is experiencing deflation or hyperinflation. The empirical results show that the price of inflation risk is significantly negative. The inflation-based ICAPM outperforms the three- and five-factor asset pricing models of Fama and French (1993, 2015), especially at stock-level. Furthermore, inflation satisfies the restrictions on time series and cross-sectional behavior of state variables, implying that the model is consistent with ICAPM.

Keywords: Intertemporal CAPM; Cross-sectional of expected returns; Inflation risk; China's stock market (search for similar items in EconPapers)
JEL-codes: E31 E44 G11 G12 G15 G18 O16 O53 P20 P34 (search for similar items in EconPapers)
Date: 2021
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Persistent link: https://EconPapers.repec.org/RePEc:eee:pacfin:v:68:y:2021:i:c:s0927538x21001086

DOI: 10.1016/j.pacfin.2021.101601

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