Date of Award

2-1-2011

Document Type

Research Paper

First Advisor

Sharad Keny

Abstract

Time variations in expected returns are related to the business cycle. Evidence shows that expected returns are higher in economic recessions, since investors are less willing to hold risky assets, and lower in economic booms. This suggests that time variations in equity premiums should be accounted for by variables related to the business cycle. Being able to model equity premiums helps investors optimize their portfolios. Therefore, we develop a conditioning macroeconomic variable that captures time variation in risk premium across business cycles and we test its predictive power for future market returns. More specifically we look at the following macro-economic variables: dividend yield, term spread, default spread, and short-term interest rate. Our analysis uses Johansens cointegration method to look at stationary time series of the four macro variables as a new factor. We test the model’s predictive power compared to the original CAPM as well as the widely use Fama and French three factor model in order to conclude whether it is a viable alternative or improvement over current practices. Our results indicate that our model sometimes outperforms the original CAPM and performs equally to the Fama and French factor model, but these results are not statistically significant. The cointegrated term is not adding much more value to the model currently being used, although it is accounting for different influencing factors. Further study can look more in depth at combinations of the Fama and French factors with our cointegrated term and perhaps adding a momentum factor as well.

Comments

WSP Major: Analytical Studies

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