Time-varying risk premia and the cross section of stock returns

This paper develops and estimates a heteroskedastic variant of Campbell's [Campbell, J., 1993. Intertemporal asset pricing without consumption data. American Economic Review 83, 487-512] ICAPM, in which risk factors include a stock market return and variables forecasting stock market returns or variance. Our main innovation is the use of a new set of predictive variables, which not only have superior forecasting abilities for stock returns and variance, but also are theoretically motivated. In contrast with the early authors, we find that Campbell's ICAPM performs significantly better than the CAPM. That is, the additional factors account for a substantial portion of the two CAPM-related anomalies, namely, the value premium and the momentum profit.