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1 Seminal
early referencesinclude Rolf Banz (1981) and
Marc Reinganum (1981) for the size effect, and Benjamin
Grahamand David Dodd (1934), Sanjoy Basu (1977, 1983),
Ray Ball (1978), and Barr Rosenberg et al. (1985) for the
value effect. Eugene Fama and KennethFrench(1992) give
an influentialtreatmentof both effects within an integrated
framework and show that sorting stocks on past market
betas generates little variationin average returns.
1249
1250
THEAMERICANECONOMICREVIEW
DECEMBER2004
VOL.94 NO. 5
Sydney Ludvigson (2001), and Lu Zhang and Ralitsa Petkova (2002) arguethatthe CAPM might hold conditionally,
but fail unconditionally, although JonathanLewellen and
Stefan Nagel (2003) show that the magnitudeof the value
effect is too large to be explainedby the conditionalCAPM.
Tobias Adrianand FrancescoFranzoni(2004) and Lewellen
and Jay Shanken (2002) explore learning as a possible
explanation of these anomalies. Richard Roll (1977) emphasizes that tests of the CAPM are misspecified if one
cannot measure the marketportfolio correctly. While Robert Stambaugh(1982) and Shanken(1987) find thatthe tests
of the CAPM are insensitive to the inclusion of other
financial assets, Campbell (1996), Jagannathanand Wang
(1996), and Lettau and Ludvigson (2001) find that humancapital wealth may be important.Josef Lakonishok et al.
(1994), Rafael La Porta (1996), and La Porta et al. (1997)
argue that investors' irrationalitydrives the value effect.
Alon Brav et al. (2002) show that analysts' price targets
imply high subjective expected returns on growth stocks,
consistent with the hypothesis that the value effect is due to
expectationalerrors.
1251
1252
THEAMERICANECONOMICREVIEW
(1)
rt+I
DECEMBER2004
fAdt+1+j
j=o
- (Et+
- Et) E
Pirt+ l+j
NCF,t+i
NDR,t + 1
j=1
VOL.94 NO. 5
CAMPBELLAND VUOLTEENAHO:
BAD BETA, GOOD BETA
(1) to back out the cash-flow news. This practice has an importantadvantage:one does not
necessarily have to understand the short-run
dynamics of dividends; one need only understand the dynamics of expected returns.
We assume that the data are generatedby a
first-orderVAR model
(2)
NCF,t+1 = (el'
NDR,t+
+ el'X)ut+
= el XUt+1.
1253
1254
THEAMERICANECONOMICREVIEW
DECEMBER2004
Variable
Mean
Median
Stdev.
Min
Max
Autocorr.
r-M
0.004
0.629
2.868
1.653
0.009
0.550
2.852
1.522
0.056
0.643
0.374
0.374
-0.344
-1.350
1.501
1.192
0.322
2.720
3.891
2.713
0.108
0.906
0.992
0.992
TY
PE
VS
Correlations
rM,t+l
TYt+ 1
PE,+
VSt +
1
0.071
-0.006
-0.030
0.071
1
-0.253
0.423
-0.006
-0.253
1
-0.320
-0.030
0.423
-0.320
1
0.103
0.070
-0.090
-0.025
0.065
0.906
-0.263
0.425
0.070
-0.248
0.992
-0.322
-0.031
0.420
-0.318
0.992
rMt+
TYt+ 1
PEt+ 1
V+ 1
rM,t
TYt
PEt
VSt
Notes: The table shows the descriptive statistics of the VAR state variables estimated from the full sample period
1928:12-2001:12, 877 monthly data points. rM is the excess log returnon the CRSP value-weight index. TYis the term yield
spreadin percentagepoints, measuredas the yield differencebetween ten-yearconstant-maturitytaxablebonds and short-term
taxable notes. PE is the log ratio of the S&P 500's price to the S&P 500's ten-year moving average of earnings. VS is the
small-stock value-spread, the difference in the log book-to-marketratios of small value and small growth stocks. The
small-value and small-growthportfolios are two of the six elementaryportfolios constructedby Davis et al. (2000). "Stdev."
denotes standarddeviation and "Autocorr."the first-orderautocorrelationof the series.
VOL.94 NO. 5
1255
CAMPBELLAND VUOLTEENAHO:
BAD BETA, GOOD BETA
TABLE2-VAR PARAMETER
ESTIMATES
Constant
e,t
TY,
PE,
VS,
R2 %
-0.014
[0.005]
(0.007)
-0.013
[0.006]
(0.008)
2.57
F
5.34
rMt+
?0.062
[0.020]
(0.026)
0.094
[0.033]
(0.034)
0.006
[0.003]
(0.003)
TYt+ 1
0.046
[0.097]
(0.012)
0.046
[0.165]
(0.170)
0.879
[0.016]
(0.017)
-0.036
[0.026]
(0.031)
0.082
[0.028]
(0.036)
82.41
1.02X 103
PEt+ 1
0.019
[0.013]
(0.017)
0.519
[0.022]
(0.022)
0.002
[0.002]
(0.002)
0.994
[0.004]
(0.004)
-0.003
[0.004]
(0.005)
99.06
2.29x 104
VSt+ 1
0.014
[0.017]
(0.024)
-0.005
[0.029]
(0.028)
0.002
[0.003]
(0.003)
0.000
[0.005]
(0.006)
0.991
[0.005]
(0.008)
98.40
1.34X 104
corr/std
rMt+1i
TY+ 1
PEt+ 1
VS+ 1
rMt
00.055
(0.003)
0.018
(0.048)
0.777
(0.018)
-0.052
(0.052)
TY+
PE, 1
0.018
(0.048)
0.268
(0.013)
0.018
(0.039)
-0.012
(0.034)
0.777
(0.018)
0.018
(0.039)
0.036
(0.002)
-0.086
(0.045)
VSt
-0.052
(0.052)
-0.012
(0.034)
-0.086
(0.045)
0.047
(0.003)
Notes: The table shows the OLS parameterestimates for a first-orderVAR model including a constant,the log excess market
return (rM),term yield spread (TY), price-earningsratio (PE), and small-stock value spread (VS). Each set of three rows
correspondsto a differentdependentvariable.The first five columns reportcoefficients on the five explanatoryvariables,and
the remainingcolumns show R2 and F statistics. OLS standarderrorsare in squarebracketsand bootstrapstandarderrorsin
parentheses.Bootstrapstandarderrorsare computedfrom 2,500 simulatedrealizations.The table also reportsthe correlation
matrix of the shocks with shock standarddeviations on the diagonal, labeled "corr/std."Sample period for the dependent
variables is 1929:1-2001:12, 876 monthly data points.
may reflect short-termmomentum in stock returns, but it may also reflect the fact that the
recent history of returnsis correlatedwith earnings news that is not yet reflectedin our lagged
earningsmeasure.Finally, the small-stockvalue
spreadis also a highly persistentAR(1) process.
Table 3 summarizesthe behavior of the implied cash-flow news and discount-rate news
componentsof the marketreturn.The top panel
shows that discount-ratenews has a standard
deviation of about 5 percent per month, much
largerthanthe 2.5-percentstandarddeviation of
cash-flow news. This is consistent with the finding of Campbell(1991) that discount-ratenews
is the dominantcomponentof the marketreturn.
The table also shows that the two components
of returnare almost uncorrelatedwith one another. This finding differs from Campbell
1256
THEAMERICANECONOMICREVIEW
TABLE 3-CASH-FLOW
News covariance
NCF
NDR
Shock correlations
rm shock
TY shock
PE shock
VS shock
DECEMBER2004
NcF
NDR
0.00064
(0.00022)
0.00015
(0.00037)
0.00015
(0.00037)
0.00267
(0.00070)
News corr/std
NCF
NDR
NcF
NDR
0.0252
(0.004)
0.114
(0.232)
0.114
(0.232)
0.0517
(0.007)
NCF
NDR
Functions
NCF
NDR
0.352
(0.224)
0.128
(0.134)
-0.204
(0.238)
-0.493
(0.243)
-0.890
(0.036)
0.042
(0.081)
-0.925
(0.039)
-0.186
(0.152)
rm shock
0.602
(0.060)
0.011
(0.013)
-0.883
(0.104)
-0.283
(0.160)
-0.398
(0.060)
0.011
(0.013)
-0.883
(0.104)
-0.283
(0.160)
TY shock
PE shock
VS shock
Notes: The table shows the propertiesof cash-flow news (NCF)and discount-ratenews (NDR)implied by the VAR model of
Table 2. The upper-left section of the table shows the covariance matrix of the news terms. The upper-rightsection shows
the correlationmatrixof the news terms with standarddeviationson the diagonal.The lower-left section shows the correlation
of shocks to individual state variables with the news terms. The lower-rightsection shows the functions (el' + el'k, el'X)
that map the state-variableshocks to cash-flow and discount-ratenews. We define X = pr(I - pr)- , where r is the
estimated VAR transitionmatrix from Table 2 and p is set to 0.95 per annum. rm is the excess log returnon the CRSP
value-weight index. TYis the term yield spread.PE is the log ratio of the S&P 500's price to the S&P 500's ten-yearmoving
average of earnings. VS is the small-stock value-spread,the difference in log book-to-marketsof value and growth stocks.
Bootstrap standarderrors (in parentheses)are computed from 2,500 simulatedrealizations.
VOL.94 NO. 5
CAMPBELLAND VUOLTEENAHO:
BAD BETA, GOOD BETA
.I
*
.
0
z
1257
.
,t
LI
a)
0
0
cn
1940
1950
1960
1970
1980
1990
2000
3-
2?
1
i'
Notes: This figure plots the cash-flow news and negative of discount-ratenews, smoothed with a trailing exponentially
weighted moving average. The decay parameteris set to 0.08 per month, and the smoothed news series are generated as
MAt(N)= 0.08Nt + (1 - 0.08)MA,_ i(N). The dotted vertical lines denote NBER business-cycle troughs.The sample period
is 1929:1-2001:12.
Pi,CF-
Cov(ri,t, NC,t)
r,)
Var(ro,t Et-_ rM,t)
(5) -
3Pi,DR
Cov(r,t, -NDRt)
- E-1 re,t)
Var(rmt
divides by the total varianceof unexpectedmarket returns,not the variance of cash-flow news
or discount-ratenews separately. This implies
that the cash-flow beta and the discount-rate
beta add up to the total marketbeta
(6)
Pi,M
Pi,CF
Pi,DR.
1258
THEAMERICANECONOMICREVIEW
DECEMBER2004
VOL.94 NO. 5
1259
CAMPBELLAND VUOLTEENAHO:
BAD BETA, GOOD BETA
TABLE4-CASH-FLOW AND DISCOUNT-RATE
BETASIN THEEARLYSAMPLE
cCF
Small
2
3
4
Large
Diff.
IDR
Small
2
3
4
Large
Diff.
/CF
Growth
0.53
0.30
0.30
0.20
0.20
-0.33
[0.11]
[0.06]
[0.06]
[0.05]
[0.05]
[0.09]
-0.45
[0.09]
[0.06]
[0.05]
[0.05]
[0.05]
-0.26
Growth
1.32
1.04
1.13
0.87
0.88
[0.06]
0.40
0.36
0.31
0.31
0.28
[0.15]
1.46
1.15
1.01
0.97
0.82
-0.64
Lo rM
[0.08]
[0.06]
[0.06]
[0.05]
[0.06]
-0.12
[0.05]
0.42
0.38
0.35
0.35
0.33
[0.19]
[0.11]
[0.08]
[0.08]
[0.07]
[0.15]
1.32
1.09
1.08
0.97
0.87
-0.43
Value
[0.07]
[0.06]
[0.06]
[0.07]
[0.07]
-0.09
[0.18]
[0.11]
[0.10]
[0.07]
[0.07]
0.46
0.34
0.28
0.26
0.19
[0.04]
4
[0.14]
[0.11]
[0.10]
[0.10]
[0.09]
-0.21
[0.10]
3
[0.08]
[0.08]
[0.08]
[0.09]
[0.09]
-0.10
Diff.
-0.04
0.16
0.18
0.30
0.19
[0.08]
1.27
1.25
1.27
1.36
1.18
-0.08
Diff.
[0.15]
[0.13]
[0.12]
[0.13]
[0.12]
-0.06
0.21
0.14
0.49
0.31
[0.15]
[0.08]
[0.06]
[0.10]
[0.10]
[0.10]
Hi r
[0.07]
[0.04]
[0.04]
[0.05]
[0.06]
[0.04]
Value
1.27
1.25
1.05
1.06
1.06
[0.15]
[0.11]
[0.09]
[0.09]
[0.08]
0.49
0.45
0.47
0.50
0.40
Diff.
Lo bs
Hi bvs
0.21
0.15
[0.04]
[0.03]
0.25
0.19
[0.05]
[0.04]
0.31
0.25
[0.06]
[0.06]
0.37
0.28
[0.07]
[0.06]
0.45
0.37
[0.09]
[0.08]
0.25
0.22
[0.05]
[0.05]
Lo br
Hi bTy
0.18
0.16
[0.04]
[0.04]
0.21
0.21
[0.05]
[0.04]
0.26
0.27
[0.06]
[0.05]
0.31
0.32
[0.07]
[0.06]
0.41
0.40
[0.08]
[0.08]
0.23
0.24
[0.04]
[0.05]
JDR
Lo br
Hi
Diff.
rM
Lo bs
Hi bvs
0.73
0.64
[0.06]
[0.05]
0.87
0.75
[0.07]
[0.07]
1.04
0.96
[0.09]
[0.08]
1.20
1.09
[0.11]
[0.09]
1.46
1.30
[0.13]
[0.11]
0.73
0.66
[0.09]
[0.08]
Lo bTy
Hi bTy
0.73
0.65
[0.06]
[0.06]
0.85
0.76
[0.07]
[0.06]
1.00
0.88
[0.09]
[0.08]
1.17
1.09
[0.10]
[0.10]
1.38
1.34
[0.12]
[0.12]
0.64
0.69
[0.08]
[0.09]
Notes: The table shows the estimated cash-flow (crF) and discount-ratebetas (IDR) for the 25 ME- and BE/ME-sorted
portfolios and 20 risk-sortedportfolios. "Growth"denotes the lowest BE/ME, "value"the highest BE/ME, "small"the lowest
ME, and "large"the highest ME stocks. bvs, by, and brMare past return-loadingson value-spreadshock, term-yield shock,
and market-returnshock. "Diff."is the difference between the extreme cells. Standarderrors[in brackets]are conditionalon
the estimatednews series. Estimates are for the 1929:1-1963:6 period.
have both higher cash-flow and higherdiscountrate betas than growth stocks. An equalweighted average of the extreme value stocks
across size quintiles has a cash-flow beta 0.16
higher than an equal-weighted average of the
extreme growth stocks. The difference in estimated discount-ratebetas is 0.22 in the same
direction. Similar to value stocks, small stocks
have higher cash-flow betas and discount-rate
betas than large stocks in this sample (by 0.18
and 0.36, respectively, for an equal-weighted
average of the smallest stocks across value
quintiles relative to an equal-weighted average
of the largest stocks). In summary, value and
small stocks were unambiguously riskier than
1260
TABLE 5-CASH-FLOW
(CF
Small
2
3
4
Large
Diff.
&DR
Small
2
3
4
Large
Diff.
kCF
DECEMBER2004
THEAMERICANECONOMICREVIEW
Growth
0.06
0.04
0.03
0.03
0.03
-0.03
2
0.07
0.08
0.09
0.10
0.08
[0.06]
[0.05]
[0.04]
[0.04]
[0.03]
[0.05]
0.02
[0.05]
-0.01
[0.11]
[0.09]
[0.08]
[0.08]
[0.07]
1.18
1.07
0.95
0.89
0.74
-0.66
[0.13]
[0.11]
[0.10]
[0.09]
[0.07]
[0.12]
0.09
0.10
0.11
0.11
0.09
-0.50
[0.11]
0.09
0.11
0.12
0.11
0.11
[0.04]
[0.04]
[0.03]
[0.03]
[0.03]
[0.04]
0.02
[0.04]
-0.01
[0.09]
[0.08]
[0.07]
[0.07]
[0.07]
1.12
1.03
0.94
0.87
0.68
[0.10]
[0.08]
[0.08]
[0.07]
[0.06]
-0.44
[0.10]
1.12
0.96
0.82
0.79
0.63
-0.49
Value
0.13
0.12
0.13
0.13
0.11
[0.05]
[0.04]
[0.04]
[0.03]
[0.03]
1.37
1.22
1.11
1.05
0.87
Lo br
[0.07]
[0.06]
[0.05]
[0.05]
[0.04]
Growth
1.66
1.54
1.41
1.27
1.00
[0.04]
[0.04]
[0.04]
[0.04]
[0.03]
Diff.
0.07
0.09
0.09
0.10
0.09
[0.04]
Value
[0.09]
4
-0.44
[0.04]
[0.03]
[0.04]
[0.04]
[0.03]
[0.10]
[0.09]
[0.09]
[0.08]
[0.07]
Diff.
-0.54
-0.52
-0.47
-0.41
-0.33
[0.08]
[0.08]
[0.09]
[0.09]
[0.08]
[0.08]
Diff.
Hibr
Lo bvs
Hi bvs
0.09
0.06
[0.03]
[0.03]
0.08
0.06
[0.03]
[0.03]
0.10
0.07
[0.04]
[0.04]
0.10
0.05
[0.04]
[0.05]
0.12
0.06
[0.05]
[0.06]
0.04
-0.01
[0.04]
[0.04]
Lo by
Hi bTy
0.06
0.09
[0.03]
[0.03]
0.04
0.07
[0.03]
[0.03]
0.08
0.09
[0.04]
[0.03]
0.08
0.08
[0.04]
[0.04]
0.06
0.10
[0.06]
[0.05]
0.00
0.00
[0.04]
[0.04]
[DR
Lo bvs
Hi bvs
LobrM
0.57
[0.06]
0.67
[0.06]
0.77
0.85
[0.06]
[0.07]
0.88
1.06
[0.07]
[0.07]
1.12
1.30
[0.08]
[0.09]
1.40
1.58
[0.09]
[0.11]
0.82
0.91
[0.08]
[0.11]
Lo bY
Hi bTy
0.73
0.61
0.86
0.79
[0.07]
[0.06]
1.05
0.91
[0.07]
[0.06]
1.23
1.11
[0.08]
[0.07]
1.60
1.39
[0.12]
[0.09]
0.87
0.78
[0.10]
[0.08]
[0.07]
[0.06]
Diff.
Hibr
Notes: The table shows the estimated cash-flow (/CF) and discount-ratebetas (I%R) for the 25 ME- and BE/ME-sorted
portfolios and 20 risk-sortedportfolios. "Growth"denotes the lowest BE/ME, "value"the highest BE/ME, "small"the lowest
ME, and "large"the highest ME stocks. bvs, bTy, and br are past return-loadingson value-spreadshock, term-yield shock,
and market-returnshock. "Diff." is the difference between the extreme cells. Standarderrors[in brackets]are conditionalon
the estimated news series. Estimates are for the 1963:7-2001:12 period.
materiallyaffected by short-saleconstraintsand
other limits to arbitrage.This may help to explain the unusual behavior of the small growth
portfolio.
The bottom half of Table 4 shows the cashflow and discount-ratebetas for the risk-sorted
portfolios. Both cash-flow betas and discountrate betas are high for stocks that have had high
market betas in the past. Thus, in the early
sample period, sorting stocks by their past market betas induces a spread in both cash-flow
betas and discount-ratebetas. Sorting stocks by
their value-spreador term-spreadsensitivity induces only a relatively modest spread in either
beta.
VOL.94 NO. 5
1261
1262
DECEMBER2004
THEAMERICANECONOMICREVIEW
o.,t
(7)
E,[ri,t+] - rf,t+1+ 2
1, -Np,DR,t+ 1)
VOL.94 NO. 5
(8)
1263
CAMPBELLAND VUOLTEENAHO:
BAD BETA, GOOD BETA
E,[ri,t+] -rft
=
y7ap,i,CFp,,
+1
2
Op,tPi,DRp,t
E[Ri - Rf] =
Y72Mi,CFM +
-'Mi,DRM.
1264
THEAMERICANECONOMICREVIEW
DECEMBER2004
TABLE6-ASSET PRICING
TESTSFORTHEEARLYSAMPLE
Parameter
Factor model
Two-beta ICAPM
CAPM
less Rrf(go)
% per annum
Std. err. A
Std. err. B
0.0042
4.98%
[0.0032]
(0.0029)
0
0%
N/A
N/A
0.0023
2.76%
[0.0024]
(0.0030)
0
0%
N/A
N/A
0.0023
2.74%
[0.0028]
(0.0028)
fcF premium(gl)
% per annum
Std. err. A
Std. err. B
0.0173
20.76%
[0.0231]
(0.0266)
0.0069
8.22%
[0.221]
(0.0248)
0.0083
9.91%
[0.0167]
(0.0221)
0.0148
17.80%
[0.0175]
(0.0442)
0.0051
6.11%
[0.0046]
(0.0046)
0.0067
8.00%
[0.0034]
(0.0034)
/DR premium(g2)
% per annum
Std. err. A
Std. err. B
-0.0003
-0.41%
[0.0092]
(0.0088)
0.0066
7.93%
[0.0067]
(0.0071)
0.0041
4.95%
[0.0006]
(0.0006)
0.0041
4.95%
[0.0006]
(0.0006)
0.0051
6.11%
[0.0046]
(0.0046)
0.0067
8.00%
[0.0034]
(0.0034)
R~2
48.08%
40.26%
45.85%
37.98%
44.52%
40.26%
0.0117
[0.019]
(0.019)
0.0126
[0.024]
(0.024)
0.0119
[0.024]
(0.031)
0.0133
[0.033]
(0.099)
0.0127
[0.021]
(0.021)
0.0126
[0.027]
(0.027)
Rzb
Pricing error
5% critic. val. A
5% critic. val. B
0
0%
N/A
N/A
Notes: The table shows premia estimated from the 1929:1-1963:6 sample for an unrestrictedfactor model, the two-beta
ICAPM, andthe CAPM. The test assets are the 25 ME- andBE/ME-sortedportfoliosand 20 risk-sortedportfolios.The second
column per model constrainsthe zero-beta rate (Rzb)to equal the risk-free rate (R,f). Estimates are from a cross-sectional
regressionof average simple excess test-assetreturns(monthlyin fractions)on an interceptand estimatedcash-flow (^cF) and
discount-ratebetas (IDR). Standarderrors and critical values [A] are conditional on the estimated news series and (B)
incorporatingfull estimation uncertaintyof the news terms. The test rejects if the pricing error is higher than the listed 5
percent critical value.
Ri
= go + 9gli,CF
+ g2[i,DR
+ ei
where bar denotes time-series mean and Ri Ri - R,r denotes the sample average simple
excess returnon asset i. The implied risk-aversion coefficient can be recovered as g/g2.
Standarderrorsare producedwith a bootstrap
from 2,500 simulated realizations. Our bootstrapexperimentsamples test-asset returnsand
VAR errors,and uses the OLS VAR estimates
in Table 2 to generate the state-variabledata.
We partitionthe VAR errors and test-asset returnsinto two groups, one for 1929 to 1963 and
anotherfor 1963 to 2001, which enables us to
use the same simulatedrealizationsin subperiod
analyses. The first set of standarderrors (labelled A) conditions on estimated news terms
and generates betas and return premia separately for each simulated realization, while the
second set (labelled B) also estimates the VAR
VOL.94 NO. 5
CAMPBELLAND VUOLTEENAHO:
BAD BETA, GOOD BETA
and the news terms separately for each simulated realization. Standarderrors B thus incorporate the considerable additional sampling
uncertaintydue to the fact that the news terms
as well as betas are generatedregressors.
Below the premiaestimates, we reportthe R2
statistic for a cross-sectional regression of average returnson our test assets onto the fitted
values from the model. The regression R2 is
computed as
(11) R2 = 1 -
'2
(Re
) (Re__ )
i
1265
1266
THEAMERICANECONOMICREVIEW
15
10
5
ICAPMwithzero-beta rate
15
10
5
ICAPMwith risk-freerate
15
10
5
CAPMwithzero-beta rate
15
10
5
CAPMwith risk-freerate
DECEMBER2004
FIGURE2. PERFORMANCE
OF THECAPM AND ICAPM, 1929:1-1963:6
Notes: The four diagramscorrespondto (clockwise from the top left) the ICAPM with a free zero-betarate, the ICAPM with
the zero-beta rate constrainedto the risk-free rate, the CAPM with a constrainedzero-beta rate, and the CAPM with an
unconstrainedzero-betarate. The horizontalaxes correspondto the predictedaverage excess returnsand the vertical axes to
the sample average realized excess returns.The predictedvalues are from regressionspresentedin Table 6. Trianglesdenote
the 25 ME and BE/ME portfolios and asterisks the 20 risk-sortedportfolios.
the zero-beta rate and the risk price for discount-ratenews, and thus it pins down the total
returngeneratedby a unit of discount-ratebeta.
Since estimated discount-ratebetas are noisy,
estimates of this model can behave extremely
badly even if the model is true.
The two-beta model with an unrestrictedrisk
price assigns an even lower risk price to discount-ratebeta than the variance of the market
return.This would be consistentwith a modified
model in which a conservativerationalinvestor
holds a portfolio that contains Treasurybills as
well as equities. The implied shareof equities in
the portfolio is 60 percent in the model with a
restrictedzero-beta rate, and slightly below 40
percent in the model with an unrestrictedzero-
VOL.94 NO. 5
1267
TABLE7-ASSET PRICING
TESTSFORTHEMODERN
SAMPLE
Parameter
Factor model
CAPM
Two-beta ICAPM
0.0009
1.05%
[0.0029]
(0.0033)
0
0%
N/A
N/A
-0.0009
-1.04%
[0.0031]
(0.0031)
0
0%
N/A
N/A
0.0069
8.24%
[0.0026]
(0.0026)
0.0529
63.47%
[0.0178]
(0.0325)
0.0572
68.59%
[0.0163]
(0.0444)
0.0575
69.04%
[0.0182]
(0.0262)
0.0483
57.92%
[0.0272]
(0.0423)
-0.0007
-0.83%
[0.0034]
(0.0034)
0.0051
6.10%
[0.0023]
(0.0023)
/DR
premium (g2)
% per annum
Std. err. A
Std. err. B
0.0007
0.88%
[0.0033]
(0.0085)
0.0012
1.44%
[0.0031]
(0.0099)
0.0020
2.43%
[0.0002]
(0.0002)
0.0020
2.43%
[0.0002]
(0.0002)
-0.0007
-0.83%
[0.0034]
(0.0034)
0.0051
6.10%
[0.0023]
(0.0023)
f?2
52.10%
51.59%
49.26%
47.41%
3.10%
Pricing error
5% critic. val. A
5% critic. val. B
0.0271
[0.028]
(0.030)
0.0269
[0.042]
(0.071)
0.0272
[0.051]
(0.051)
0.0275
[0.314]
(0.488)
0.0592
[0.032]
(0.032)
0
0%
N/A
N/A
-61.57%
0.0875
[0.046]
(0.046)
Notes: The table shows premia estimated from the 1963:7-2001:12 sample for an unrestrictedfactor model, the two-beta
ICAPM,and the CAPM. The test assets are the 25 ME- and BE/ME-sortedportfoliosand 20 risk-sortedportfolios.The second
column per model constrains the zero-beta rate (RZb)to equal the risk-free rate (R,f). Estimates are from a cross-sectional
regressionof average simple excess test-assetreturns(monthlyin fractions)on an interceptand estimatedcash-flow (crF) and
discount-ratebetas (/DR). Standarderrors and critical values [A] are conditional on the estimated news series and (B)
incorporatingfull estimation uncertaintyof the news terms. The test rejects if the pricing error is higher than the listed
5-percent critical value.
beta rate. This model generates cross-sectional R2 statistics slightly above 50 percent.
A visual summaryof these resultsis providedby
Figure3.
Another way to evaluate the performanceof
our model is to compare it to less theoretically
structuredmodels. We do this in two ways.
First, we compare our restrictedICAPM model
to a model whose factors are the four innovations from our VAR system, with unrestricted
risk prices. In the modem sample, the four unrestricted risk prices line up almost perfectly
with those implied by our restrictedmodel. Second, we compare the two-beta model to the
influential three-factor model of Fama and
French (1993). In the early subsample, the
cross-sectionalR2 statistic for the Fama-French
three-factor model is 10 percentage points
higher than that for our two-beta model with an
unconstrainedzero-beta rate, and 1 percentage
point higher with a zero-betarate constrainedto
the risk-freerate. In the modem subsample,the
Fama-Frenchmodel outperformsthe two-beta
model by 30 and 26 percentagepoints, respec-
1268
DECEMBER2004
THEAMERICANECONOMICREVIEW
A
10
5
ICAPMwithzero-beta rate
A
5
10
CAPMwithzero-beta rate
5
10
ICAPMwith risk-freerate
A
10
5
CAPMwith risk-freerate
FIGURE
OFTHECAPM ANDICAPM, 1963:7-2001:12
3. PERFORMANCE
Notes: The four diagramscorrespondto (clockwise from the top left) the ICAPM with a free zero-betarate, the ICAPM with
the zero-beta rate constrainedto the risk-free rate, the CAPM with a constrainedzero-beta rate, and the CAPM with an
unconstrainedzero-betarate. The horizontalaxes correspondto the predictedaverage excess returnsand the vertical axes to
the sample averagerealized excess returns.The predictedvalues are from regressionspresentedin Table 7. Trianglesdenote
the 25 ME and BE/ME portfolios and asterisks the 20 risk-sortedportfolios.
VOL.94 NO. 5
1269
First, we
estimate
covariances
Covt(ri,t,
and Cov(ri,t,-NDR,t-NDR, 1)
for each test asset using a rolling 3-year (36month) window. We use these rolling covariance estimates as instrumentsthatpredictfuture
covariances. Second, we regress the realized
cross products (NcF,t + NcF,t -)ri,t
and
NCF,t + NCF,t-1)
(-NDR,t
NDR,t
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THEAMERICANECONOMICREVIEW
DECEMBER2004
measurenews aboutvolatility-adjusteddiscount
rates rather than simply news about discount
rates themselves. We believe that the properties
of market discount-ratenews will be fairly insensitive to any volatility adjustment, since
movements in market volatility appear to be
relatively short-lived. Related to this, we can
allow for dynamically changing betas rather
than assuming, as we have done here, that betas
are constantover long periods of time. Andrew
Ang and Chen (2003) and Franzoni(2002) discuss alternativemethods for estimatingthe evolution of betas over time.
We have assumed that the rationallong-term
investor always holds a constant proportionof
her assets in equities. But if expected returnson
stocks vary over time while the risk-freeinterest
rate and the volatility of the stock market are
approximatelyconstant, the long-term investor
has an obvious incentive to time the market
strategically.In future work we plan to extend
the model to examine whether a long-term investor who strategically allocates wealth into
stocks and bonds would be better off overweighting small and value stocks than holding
the stock portion of her portfolio at market
weights. With this extension it will be important
to handle changing volatility correctly, since a
strategic market-timingportfolio will be heteroskedastic even if the stock marketportfolio
is homoskedastic.
We have nothingto say aboutthe profitability
of momentum strategies (Ball and P. Brown,
1968; Narasimhan Jegadeesh and Titman,
1993). Although we have not examined this
issue in detail, we are pessimistic about the
two-beta model's ability to explain average returns on portfolios formed on past one-year
stock returns or on recent earnings surprises.
Stocks with positive past news and high shorttermexpected returnsare likely to have a higher
fractionof theirbetas due to discount-ratebetas,
and thus are likely to have even lower return
predictionsin the ICAPM than the already-toolow predictionsof the static CAPM.
Our model is silent on what is the ultimate
source of variationin the market'sdiscountrate.
The mechanismthat causes the market'soverall
valuation level to fluctuatewould have to meet
at least two criteria to be compatible with our
simple intertemporalasset-pricing model. The
VOL.94 NO. 5
shock to discount rates cannot be perfectly correlatedwith the shock to cash flows. Also, states
of the world in which discount rates increase
while expected cash flows remain constant
should not be states in which marginal utility
is unusually high for other reasons. If marginal utility is very high in those states, the
discount-rate risk factor will have a high premium instead of the low premium we detect
in the data.
We have estimated the cash-flow and
discount-ratebetas of value and growth stocks
from the behavior of their returns, without
showing how these betas are linked to the underlying cash flows of value and growth companies. Similar to our decomposition of the
marketreturn,an individual firm's stock return
can be split into cash-flow and discount-rate
news. Through this decomposition, a stock's
cash-flow and discount-ratebetas can be further
decomposed into two partseach, along the lines
of Campbelland JianpingMei (1993) and Vuolteenaho (2002), and this decomposition might
yield interestingadditionalinsights. Preliminary
results in Campbellet al. (2003) suggest thatthe
cash-flow propertiesof growth and value stocks
are the main determinantsof theirbetas with the
cash-flow and discount-ratenews on the aggregate stock market.Ravi Bansal et al. (2003) also
model the cash flows of value and growthstocks
in relationto their risks in a consumption-based
asset pricing model.
Finally, our model has interesting implications for corporatefinance, specifically for the
methodsused by corporationsto calculatea cost
of capital when evaluating investmentprojects.
The two-beta model suggests that the most importantdeterminantof the cost of capital is not
the market beta of a project but its cash-flow
beta. This is consistent with the suggestion of
William Brainardet al. (1991) that "fundamental beta" estimated from cash flows could improve the empiricalperformanceand usefulness
of the CAPM. Cash-flow beta could be estimated using an econometric model, as we do
here, but it is possible that simpler methods,
such as estimating beta over long horizons or
regressing returns on aggregate corporate
profitability, would also provide useful estimates of cash-flow beta and thus of the cost of
capital.
1271
IV. Conclusions
In his discussion of empirical evidence on
market efficiency, Fama (1991) writes: "In
the end, I think we can hope for a coherent
story that (1) relates the cross-section properties of expected returns to the variation of
expected returns through time, and (2) relates
the behavior of expected returns to the real
economy in a rather detailed way." In this
paper, we have presented a model that meets
the first of Fama's objectives and shows empirically that Merton's (1973) ICAPM helps
to explain the cross-section of average stock
returns.
We propose a simple and intuitive two-beta
model that captures a stock's risk in two risk
loadings: cash-flow beta and discount-ratebeta.
The returnon the marketportfolio can be split
into two components,one reflectingnews about
the market's future cash flows and the other
reflecting news about the market's discount
rates. A stock's cash-flow beta measures the
stock's returncovariance with the former component and its discount-rate beta its return
covariancewith the lattercomponent.Intertemporal asset pricing theory suggests that the
"bad"cash-flow beta should have a higher price
of risk than the "good"discount-ratebeta. Specifically, the ratio of the two risk prices equals
the risk aversion coefficient that makes an investor contentto hold the aggregatemarket,and
the "good"risk price should equal the variance
of the returnon the market.
Empirically, we find that value stocks and
small stocks have considerably higher cashflow betas than growth stocks and large stocks,
and this can explain their higher average returns.The post-1963 negative CAPM alphas of
growth stocks are explained by the fact that
their betas are predominantlyof the good variety. The model also explains why the sort on
past CAPM betas induces a strong spread in
average returnsduringthe pre-1963 sample but
little spread during the post-1963 sample. The
post-1963 CAPM beta sort induces a postranking spread only in the good discount-rate
beta, which carries a low premium.Finally, the
model achieves these successes with the
discount-ratepremium constrained to the prediction of the intertemporalmodel.
1272
THEAMERICANECONOMICREVIEW
DECEMBER2004
Ball, Ray and Brown,P. "An EmpiricalEvaluation of Accounting Income Numbers."Journal of Accounting Research, 1968, 6(2), pp.
159-78.
Bansal,Ravi; Dittmar,RobertF. and Lundblad,
ChristianT. "InterpretingRisk Premiaacross
Size, Value, and IndustryPortfolios."Unpublished Paper, 2003.
Banz, Rolf W. "The Relation between Return
and MarketValue of Common Stocks."Journal of Financial Economics, 1981, 9(1), pp.
3-18.
Basu,Sanjoy."InvestmentPerformanceof Common Stocks in Relation to Their PriceEarnings Ratios: A Test of the Efficient
Market Hypothesis." Journal of Finance,
1977, 32(3), pp. 663-82.
Basu, Sanjoy."The Relationshipbetween Earnings Yield, Market Value and Return for
NYSE Common Stocks: FurtherEvidence."
Journal of Financial Economics, 1983, 12(1),
pp. 129-56.
Black, Fischer. "Capital Market Equilibrium
with RestrictedBorrowing."Journal of Business, 1972, 45(3), pp. 444-55.
Brainard,William C.; Shapiro,MatthewD. and
Shoven, John B. "FundamentalValue and
Market Value," in W. C. Brainard,W. D.
Nordhausand H. W. Watts,eds., Money,macroeconomics,and economicpolicy: Essays in
honor of James Tobin. Cambridge,MA, and
London:MIT Press, 1991, pp. 277-307.
Brav, Alon; Lehavy, Reuven and Michaely, Roni.
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Right." National Bureau of Economic Research, Inc., NBER Working Papers: 10131,
2003a.
Cohen, Randolph B.; Polk, Christopher and
Vuolteenaho, Tuomo. "The Value Spread."
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BAD BETA, GOOD BETA
1275