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An inflation-based ICAPM in China

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  • Zhang, Han

Abstract

There is a consensus regarding the weak link between China's stock market and its macro-economy. In contrast, this paper shows that inflation has a strong pricing ability for China's stock returns. We develop a two-factor intertemporal capital asset pricing model (ICAPM) of Merton (1973), in which inflation is a state variable. The theoretical results show that the marginal wealth value is high, when the economy is experiencing deflation or hyperinflation. The empirical results show that the price of inflation risk is significantly negative. The inflation-based ICAPM outperforms the three- and five-factor asset pricing models of Fama and French (1993, 2015), especially at stock-level. Furthermore, inflation satisfies the restrictions on time series and cross-sectional behavior of state variables, implying that the model is consistent with ICAPM.

Suggested Citation

  • Zhang, Han, 2021. "An inflation-based ICAPM in China," Pacific-Basin Finance Journal, Elsevier, vol. 68(C).
    • Handle: RePEc:eee:pacfin:v:68:y:2021:i:c:s0927538x21001086
    DOI: 10.1016/j.pacfin.2021.101601
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    More about this item

    Keywords

    Intertemporal CAPM; Cross-sectional of expected returns; Inflation risk; China's stock market;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
    • O53 - Economic Development, Innovation, Technological Change, and Growth - - Economywide Country Studies - - - Asia including Middle East
    • P20 - Political Economy and Comparative Economic Systems - - Socialist and Transition Economies - - - General
    • P34 - Political Economy and Comparative Economic Systems - - Socialist Institutions and Their Transitions - - - Finance

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