One-factor Return Model for All Asset Classes?
March 15, 2013
Is downside risk the critical driver of investor asset valuation? In the January 2013 version of their paper entitled “Conditional Risk Premia in Currency Markets and Other Asset Classes”, Martin Lettau, Matteo Maggiori and Michael Weber explore the ability of a simple downside risk capital asset pricing model (DR-CAPM) to explain and predict asset returns. Their approach captures the idea that downside risk aversion makes investors view assets with high beta during bad market conditions as particularly risky. For all asset classes (but focusing on currencies), they define bad market conditions as months when the excess return on the broad value-weighted U.S. stock market is less than 1.0 standard deviation below its sample period average. To test DR-CAPM on currencies, they rank a sample of 53 currencies by interest rates into six portfolios, excluding for some analyses those currencies in highest interest rate portfolio with annual inflation at least 10% higher than contemporaneous U.S. inflation. They calculate the monthly return for each currency as the sum of its excess interest rate relative to the dollar and its change in value relative to the dollar. They then calculate overall and downside betas relative to the U.S. stock market based on the full sample. They extend tests of DR-CAPM to six portfolios of U.S. stocks sorted by size and book-to-market ratio, five portfolios of commodities sorted by futures premium and six portfolios of government bonds sorted by probability of default, and to multi-asset class combinations. They also compare DR-CAPM to optimal models based on principal component analysis within and across asset classes. Using monthly prices and characteristics for currencies and U.S. stocks during January 1974 through March 2010, for commodities during January 1974 through December 2008 and for government bonds during January 1995 through March 2010, they find that: (more…)