Augmenting the Intertemporal CAPM with Inflation: Some Further Evidence in Alternative Models

Abstract

A few papers find that the inflation risk is a missing factor of their specified Intertemporal Capital Asset Pricing Models (ICAPM) in pricing 25 size and book-to-market portfolios. We extend their work via investigating another two specified alternative ICAPM models (the Michel (2009) ICAPM and the Hahn and Lee (2006) ICAPM) and Hou et al. (2011)’s three-factor model. We also find significant evidence that the ICAPMs augmented with inflation perform better than the original ICAPMs, while Hou et al. (2011)’s model augmented with inflation also performs better than original model. The augmented alternative model can achieve a goodness-of-fit with the fewest number of factors thus avoiding or alleviating the over-fit problem.