An Intertemporal CAPM with Stochastic Volatility

Abstract

This paper extends the approximate closed-form intertemporal capital asset pricing model of Campbell (1993) to allow for stochastic volatility. The return on the aggregate stock market is modeled as one element of a vector autoregressive (VAR) system, and the volatility of all shocks to the VAR is another element of the system. Our estimates of this VAR reveal novel low-frequency movements in market volatility tied to the default spread. We show that growth stocks underperform value stocks because they hedge two types of deterioration in investment opportunities: declining expected stock returns, and increasing volatility.