Conditioning the Capital Asset Pricing Model to Incorporate Macro-Economic Based Variables

Time variations in expected returns are related to business cycle. Evidence shows that expected returns are higher in economic recessions, since investors are less willing to hold risky assets, and lower in economic booms. This suggests that time variations in equity premiums should be accounted for by variables related to business cycle. We will develop a conditional macroeconomic variable that captures time variation in risk premium across business cycles and test predictive power of this variable for future market returns. More specifically we will be looking at the following macro-economic variables: dividend yield, term spread, default spread, short-term interest rate, and consumption.