Evaluating the Conditional CAPM using Consumption-based State Variables: Evidence from the Korean Stock Market

Abstract

In this study, we evaluate the empirical performance of conditional asset pricing models using consumption-based measures as state variables. We incorporate three consumption variables known to forecast the equity risk premium as conditioning variables to capture time variations in the risk premium. These three variables are the consumption-aggregate wealth ratio, the surplus consumption ratio, and the labor income to consumption ratio. The asset pricing models evaluated in this study are the CAPM, the CAPM with human capital, the consumption CAPM, and the Fama-French three-factor model. We compare the unconditional and conditional specifications of these four asset pricing models using the two-pass cross-sectional regression methodology, using the size, book-to-market, turnover, and idiosyncratic risk sorted portfolios and sector portfolios as test assets. We demonstrate that the conditional CAPM with human capital performs far better than the unconditional specifications and about as well as the Fama and French three-factor model in explaining the crosssection of average stock returns in Korea.