Abstract - Dynamic Present Values and the Intertemporal CAPM
We show that the intertemporal CAPM can be consistent with dynamic present value computations only if future cash flows are exogenously assumed to be proportional to systematic risk. We argue that most empirical studies of the ICAPM, in continuous and discrete time, inadvertently makes this strong assumption. We study a general model in which we relax the implicit correlation assumption. In this model both aggregate cash flow shocks and systematic risk shocks are priced. Our model is a traditional wealth based dynamic CAPM without intermediate consumption and dividends. The model is not derived using the Campbell-Shiller log-linearization and gives closed form exact formulas for prices and returns. An essential feature of the model is that prices respond endogenously to shocks in systematic risks such as market volatility shocks. This leads to an endogenous volatility feedback effect which can be made substantially large even with low levels of risk aversion.
Wisconsin School of Business