Return decomposition and the Intertemporal CAPM

The Intertemporal CAPM (ICAPM) from Merton (1973) has had a strong impact in empirical asset pricing leading to numerous multifactor models. This paper shows that the explanatory power of the ICAPM application by Campbell and Vuolteenaho (2004) relies critically on the computation of Dimson (1979) covariances (betas). If one employs the standard factor covariances (excluding lagged factors), the two-factor ICAPM has virtually no explanatory power for the average returns of the 25 size/book-to-market portfolios. More specifically, it is the covariance with the lagged innovation in one of the state variables (the value spread) that drives the explanatory power of the model. These results are inconsistent with the central economic intuition from the ICAPM. By specifying a more general version of the ICAPM, the fit of the model improves relative to the Campbell and Vuolteenaho (2004) model.