"Shooting" the CAPM

Lu Zhang (), Howard Kung and Hang Bai
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Howard Kung: University of British Columbia
Hang Bai: The Ohio State University

No 905, 2013 Meeting Papers from Society for Economic Dynamics

Abstract: We provide a disaster-based explanation for the failure of the CAPM in the post-Compustat sample as well as its success to explain the value premium in the long sample that includes the Great Depression. In an investment-based asset pricing model embedded with rare disasters, value stocks are more sensitive to disaster shocks than growth stocks. More important, disasters introduce strong nonlinearities in the relation between the pricing kernel and the return on wealth. The nonlinearities allow the model to explain the failure of the CAPM in samples in which disasters are not materialized. However, the CAPM explains the value premium in samples with disasters in the model, consistent with the data.

Date: 2013
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed013:905

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