Intertemporal Risk and the Cross Section of Expected Stock Returns

Abstract

The Intertemporal Capital Asset Pricing Model (ICAPM) predicts that a factor capturing changes in expected market returns should be priced in the cross section. A primary difficulty in testing the model is that the intertemporal risk factor is unobservable. This paper's Bayesian framework (i) accounts for uncertainty in the latent factor while testing the ICAPM and (ii) gauges the effect of prior information about market return predictability on ICAPM inferences. Whereas intertemporal risk is not significantly priced under uninformative priors after considering uncertainty in the hedging factor, results with priors that market returns are highly predictable support the ICAPM's theoretical predictions.