Abstract
This paper provides evidence on the degree of persistence of one of the key components of the CAPM, namely the market risk premium, as well as its volatility. The analysis applies fractional integration methods to data for the US, Germany and Japan, and for robustness purposes considers different time horizons (2, 5 and 10 years) and frequencies (monthly and weekly). The empirical findings in most cases imply that the market risk premium is a highly persistent variable which can be characterized as a random walk process, whilst its volatility is less persistent and exhibits stationary long-memory behaviour. There is also evidence that in the case of the US the degree of persistence has changed as a results of various events; this is confirmed by both endogenous break tests and the associated subsample estimates. Market participants should take this evidence into account when designing their investment strategies.
Highlights
The capital asset pricing model (CAPM), in particular its one-factor version, has been for decades the most commonly used framework to analyse the relationship between risk and return
The standard approach to calculating the cost of equity is based on the CAPM (Fernandez 2015): in a survey of the Association for Financial Professionals (AFP) 90% of the respondents said that they use the CAPM for estimating the cost of capital and making investment decisions (Jacobs and Shivdasani 2012)
This paper focuses on a key component of the CAPM, namely the market risk premium (MRP), which is defined as the difference between the expected return on a market portfolio and the risk-free rate, and is the slope of the security market line (SML), a graphical representation of the CAPM
Summary
The capital asset pricing model (CAPM), in particular its one-factor version, has been for decades the most commonly used framework to analyse the relationship between risk and return. Fama and MacBeth (1973) estimated this model for NYSE stocks and found a positive relationship between average return and market volatility in the period 1926–1968. The aim of the analysis is to provide evidence about some of its statistical properties as well as those of its volatility, in particular their degree of persistence, by applying fractional integration techniques to a set of data from the US, Germany and Japan, namely the biggest economies in America, Europe and Asia respectively in terms of nominal GDP over most of the time period considered in our study. The layout of the paper is the following: Section 2 reviews the relevant literature; Section 3 describes the data and the econometric framework; Section 4 discusses the empirical findings; Section 5 offers some concluding remarks
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