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The CAPM Strikes Back? An Investment Model with Disasters

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  • Hang Bai
  • Kewei Hou
  • Howard Kung
  • Lu Zhang

Abstract

Value stocks are more exposed to disaster risk than growth stocks. Embedding disasters into an investment-based asset pricing model induces strong nonlinearity in the pricing kernel. Our single-factor model reproduces the failure of the CAPM in explaining the value premium in finite samples in which disasters are not materialized, and its relative success in samples in which disasters are materialized. The relation between pre-ranking market betas and average returns is flat in simulations, despite a strong positive relation between true market betas and expected returns. Evidence in the long U.S. sample from 1926 to 2014 lends support to the model’s key predictions.

Suggested Citation

  • Hang Bai & Kewei Hou & Howard Kung & Lu Zhang, 2015. "The CAPM Strikes Back? An Investment Model with Disasters," NBER Working Papers 21016, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:21016
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    References listed on IDEAS

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    3. Dinesh Gajurel & Mardi Dungey & Wenying Yao & Nagaratnam Jeyasreedharan, 2020. "Jump Risk in the US Financial Sector," The Economic Record, The Economic Society of Australia, vol. 96(314), pages 331-349, September.
    4. Samuel Xin Liang, 2019. "What drives stock returns in Japan?," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 33(1), pages 39-69, March.
    5. Bianchi, Francesco, 2008. "Rare Events, Financial Crises, and the Cross-Section of Asset Returns," MPRA Paper 20831, University Library of Munich, Germany, revised 01 Jan 2010.
    6. Jun Li, 2019. "Explaining Momentum and Value Simultaneously," Management Science, INFORMS, vol. 64(9), pages 4239-4260, September.

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    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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