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The CAPM Strikes Back? An Investment Model with Disasters

Hang Bai, Kewei Hou, Howard Kung, Lu Zhang

NBER Working Paper No. 21016
Issued in March 2015
NBER Program(s):The Asset Pricing Program, The Corporate Finance Program, The Economic Fluctuations and Growth Program

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.

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Document Object Identifier (DOI): 10.3386/w21016

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