A derivation of the ICAPM in a very general framework and previous theoretical work, argue for the relative risk aversion (RRA) coefficient to be both time-varying and countercyclical. The variables that represent proxies for the cyclical component of RRA are the market dividend yield, default spread, smoothed earnings yield and industrial production growth, all being highly correlated with the business cycle. In addition, the value spread - a proxy for the relative valuation of value stocks versus growth stocks - is included as a determinant of risk aversion. The results show that risk aversion is countercyclical, and the ICAPM with time-varying RRA performs better than the Bad beta good beta model (BBGB) from Campbell and Vuolteenaho (2004). The results from an augmented scaled ICAPM show that the market return has a negative effect on risk aversion, thus risk aversion seems to be affected by both business conditions and financial wealth. The estimates of the average RRA coefficient seem reasonable and plausible, and the model is able to capture a significant decline in risk-aversion in the 90's, in line with the mounting evidence from academics and practioneers. When compared against alternative factor models - CAPM, Fama-French 3 factor and Fama-French 4 factor models - the scaled ICAPM performs much better than the CAPM, and compares reasonably well against the Fama-French models. A crucial result relies on the fact that the scaled ICAPM models do a good job in pricing both the "extreme" small-growth portfolio and all the book-to-market quintiles, which is mainly due to the presence of the factor related with time-varying risk-aversion. Overall, the results of this paper offer a fundamental explanation - time-varying risk aversion - for the value premium. Preliminary results suggest that the ad-doc HML and UMD factors, at least partially, measure the same types of risks as the ICAPM with time-varying risk aversion
