Abstract
In this paper, we test a simple Merton-style (1973) intertemporal capital asset pricing model (ICAPM) by allowing for time variations in certain key state variables for a sample of firms listed on the Karachi Stock Exchange. We evaluate the model’s ability to account for returns on portfolios sorted by size, book-to-market ratio, and momentum. Our findings provide evidence of an intertemporal asset pricing setting with significant coefficients for innovations in state variables. Innovations in dividend yield, term, and risk-free rates are systematically priced in time series of returns and should be considered when evaluating the risk premium for investments. We do not find the market premium to be a significant variable, which suggests that a traditional capital asset pricing model is unable to capture variations in stock returns for our sample period. These results favor the use of an ICAPM framework for optimal decision-making.
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