Asset Returns and Economic Risk

Abstract

The capital asset pricing model (CAPM), favored by financial researchers and practitioners fifteen years ago, holds that the extra return on a risky asset comes from bearing market risk only. But newer evidence supports the intertemporal CAPM (I-CAPM) theory (Merton 1973), which suggests that the premium on any risky asset is related not only to market risk but also to additional economic variables. This article reviews and interprets recent advances in the asset pricing literature. The study seeks to shed light on the sources of economic risk that investors should track and hedge against and the sign of the risk premia commanded by economic and financial risks. The author empirically measures the impact of prespecified financial and economic variables on the risk-return trade-off by looking at how they affect (or predict) the mean and the variance of asset returns. The analysis shows that variables such as the market portfolio, the term structure, the default premium, and the consumption-aggregate wealth ratio positively affect average asset returns and command positive risk premia while the inflation portfolio negatively affects returns and commands a negative premium. The article also provides extensive evidence of time variation in economic risk premia, showing that expected compensation for bearing different sorts of risk is larger at some times and smaller at others depending on economic conditions.