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

When the cost of hedging is zero, the conditional CAPM holds, as shown by empirical testing. The intercepts in the regression analysis are not statistically different from zero, indicating that the conditional CAPM successfully explains the level of asset returns. However, the unconditional betas do not explain the cross section of average asset returns, leading to the failure of the unconditional CAPM. This study rationalizes the coexistence of these two results.