Modeling Covariance Risk in Merton's ICAPM

Abstract

We propose a new method for constructing the hedge component in Merton's ICAPM that uses a daily summary measure of economic activity to track time-varying investment opportunities. We then use nonparametric projections to compute a robust estimate of the conditional covariance between stock market returns and our daily economic activity index. We find that the new conditional covariance risk measure plays an important role in explaining time variation in the equity risk premium. Specification tests as well as out-of-sample forecasts of aggregate stock returns suggest that the new covariance risk measure performs well compared to alternative covariance measures previously proposed in the literature.

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