Augmenting the Intertemporal CAPM with Macro Factors: What Does Momentum Proxy For?

Abstract

We extend the intertemporal capital asset pricing model (ICAPM) with two macro factors commonly used in the arbitrage pricing theory (APT); namely, inflation risk and industrial production cycle. We find consistent evidence that our proposed ICAPM-APT augmented model performs better than the original ICAPM models. Regarding variations of cross-sectional returns, the results suggest that the inflation risk is the key additional factor of the asset pricing model for the 25 size and book-to-market portfolios, while only the industrial production cycle proves a crucial factor for the 25 size and momentum portfolios. Furthermore, when the industrial production cycle is present in the model, the momentum factor becomes superfluous. This suggests that the momentum factor is an effective proxy for the industrial production cycle.