Modeling Covariance Risk in Merton's ICAPM

  title={Modeling Covariance Risk in Merton's ICAPM},
  author={Alberto G. Rossi and Allan Timmermann},
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… CONTINUE READING

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