Working Paper: NBER ID: w8565
Authors: Andrew W. Lo; Jiang Wang
Abstract: We derive an intertemporal capital asset pricing model with multiple assets and heterogeneous investors, and explore its implications for the behavior of trading volume and asset returns. Assets contain two types of risks: market risk and the risk of changing market conditions. We show that investors trade only in two portfolios: the market portfolio, and a hedging portfolio, which allows them to hedge the dynamic risk. This implies that trading volume of individual assets exhibit a two-factor structure, and their factor loadings depend on their weights in the hedging portfolio. This allows us to empirically identify the hedging portfolio using volume data. We then test the two properties of the hedging portfolio: its return provides the best predictor of future market returns and its return together with the return of the market portfolio are the two risk factors determining the cross-section of asset returns.
Keywords: No keywords provided
JEL Codes: G11; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Trading volume (G15) | Hedging portfolio trades (G13) |
| Trading volume (G15) | Market portfolio trades (G10) |
| Hedging portfolio returns (G11) | Trading volume (G15) |
| Hedging portfolio returns (G11) | Market returns (G19) |