Can we treat empirical regularities as state variables in the ICAPM? Evidence from Australia

By examining the correlation between the size, value and momentum empirical regularities and macroeconomic variables we investigate whether these regularities may be explained as risk factors within Merton's (1973) ICAPM. We examine the commodity-based Australian economy where financial asset claims are highly sensitive to macroeconomic volatility. The size and momentum premia covary pro-cyclically, while the value premium is countercyclical and negative at the business cycle peak. All three regularities become insignificant after controlling for the Chen et al. (1986) factors and a macroeconomic model successfully forecasts returns for both the size and momentum premia. Our results suggest that these regularities may be explained as macroeconomic-risk factors. We argue that covariance between macroeconomic risk and empirical regularities may explain inconsistencies in prior Australian market literature.

► Australian study on whether size, value and momentum are macroeconomic risk factors. ► We model returns on empirical regularities across the business cycle. ► Size and momentum covary pro-cyclically and value covaries counter-cyclically. ► The empirical regularities are explained by macroeconomic models. ► Results support the macroeconomic risk hypothesis.