Explaining the Failure of the Unconditional CAPM with the Conditional CAPM

When the cost of hedging is nil, the conditional capital asset pricing model (CAPM) holds. We empirically test the conditional CAPM by regressing asset returns onto the product of their conditional betas and market returns. Estimated intercepts are not statistically different from zero, implying that the conditional CAPM successfully explains the conditional level of asset returns. Yet, unconditional betas do not explain the cross section of average asset returns; the unconditional CAPMfails. We show why and how the success of the conditional CAPM actually explains the failure of the unconditional CAPM, thereby rationalizing the coexistence of these two intriguing results.

Automated summary

This study empirically tests the conditional capital asset pricing model (CAPM) and finds that it successfully explains the conditional level of asset returns when the cost of hedging is nil. However, it fails to explain the cross section of average asset returns. The study provides an explanation for the coexistence of these two apparently contradictory results.