Dynamic Present Values and the Intertemporal CAPM

Bjorn Eraker, Wenyu Wang
2011 Social Science Research Network  
We argue that intertemporal Capital Asset Pricing Model is difficult to reconcile with present value computation when investment opportunities are random and time-varying. Merton assumes a geometric price process, and argues that equilibrium can be constructed by solving for the instantaneous expected rate of return. We argue that this method is potentially inconsistent with present value computations. We derive an alternative version of the Intertemporal CAPM based explicitly on present value
more » ... y on present value computation with a strictly exogenous cash flow. Our model is derived without any a priori assumptions about the structure of the equilibrium price process. An essential feature of our model is that prices respond endogenously to shocks in expected return. In an example model, we show that shocks to stochastic volatility is negatively correlated with stock returns in equilibrium. The correlation increases in absolute magnitude with risk aversion.
doi:10.2139/ssrn.1908910 fatcat:mdzaw6lw5ngwxp3yt5cohckwcq