Joumai of Business Finance & Accounting, 16(5), Winter 1989, 0306-686X $2.

50

AN EMPIRICAL EVALUATION OF THE INTERTEMPORAL CAPITAL ASSET PRICING MODEL: THE STOCK MARKET IN SPAIN
GONZALO RUBIO*

INTRODUCTION

Previous empirical evidence on asset pricing seems to indicate that, in Spain, the traditional forms of the capital asset pricing model do not provide a satisfactory description of security returns.' Unfortunately, European equity markets have experienced little or no empirical research on more complex models of asset pricing like the one suggested by Merton in his seminal work (1973).2 Accepting that unfavorable shifts in investment opportunities can be described by future changes in interest rates, Merton argues that the equilibrium expected return is explained not only by its beta coefficient but also by the ability of the asset to protect the investor against changes in the interest rates. This hedging behavior becomes plausible by holding an additional asset or portfolio which is negatively correlated with the single state variable; i.e., the interest rate. The Intertemporal Capital Asset Pricing Model (ICAPM) can be written as: E{r,) = ^iM E{rM) +
/3,H

Eir^)

(1)

where, (r,) is the expected return on asset i in excess of the risk free rate, E{r/^^) is the expected excess return on the true market portfolio, and E(rff) is the expected return on the hedging portfolio in excess of the riskless rate. It should be noted that the underlying theory refers to moments conditional on available information at the beginning of the period over which instantaneous rates of return are measured. This paper presents an empirical test of (1) using recent developments on multivariate fmancial econometrics. In particular, this work applies an extension of the test statistic developed by Gibbons, Ross and Shanken (1986) which has a tractable fmite sample distribution under the null hypothesis. On the other hand, as recently pointed out by Shanken (1987b), multivariate statistical techniques that may be used to test unconditional asset pricing models may
'The author is from Universidad del Pai's Vasco and Instituto de Economia Publica, Spain. This paper was presented at the Fondements Theoriques de L'Economie des Marches Financiers, Association Francaise de Finance, Toulouse, in July 1987. The author would like to thank Jose M. Perez de Villarreal and Juan Urrutia of the Instituto de Economia Publica for their constructive comments. He is also grateful to the anonymous referee for his relevant suggestions, and acknowledges that any remaining deficiencies in the paper are his own. (Paper received September 1987, revised January 1988)

729

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RUBIO

be applicable in testing conditional pricing relations under changing conditional means and variances. It should be pointed out, however, that these tests implicitly impose constant (over time) betas and residual covariance matrix. This paper also reports empirical evidence on the ICAPM when these assumptions are, somewhat, relaxed. It has carefully been discussed by Roll (1977) and Shanken (1987a), that both the true market portfolio and the hedging asset are conceptual constructions which are difficult to duplicate. This implies that, in the context of the traditional CAPM, there is an implicit joint hypothesis in the sense that the stock market portfolio employed is a perfect instrument for the true value-weighted market portfolio. In the ICAPM context, the notion of a proxy is enlarged to incorporate a two-dimensional vector of variables which is assumed to account for all the variation in the return of the fundamental economic aggregate; i.e., the marginal utility of consumption. This paper is organized as follows. In the next section recent developments on multivariate fmancial econometrics are discussed. The description of the data is presented in the third section,and the fourth section reports the empirical results. Additional evidence regarding the validity of the ICAPM allowing conditional moments to vary with the levels of observable state variables is examined in the fifth section, and the final section provides a summary of the results.

MULTIVARIATE TEST OF MEAN-VARIANCE EFFICIENCY OF A PORTFOLIO OF k ASSETS

Multivariate analysis offers the advantage relative to other capital asset pricing model tests, of not requiring the exact form of the alternative pricing specification. It will be assumed throughout the next sections that the joint distribution of excess returns follows a stationary multivariate normal distribution over the period t = 1, . . . T. We defme r, to be an A^-vector of excess returns at time I, and r^i the excess return on a market portfolio index at time t. If we regress each component of r, on r^ and a constant, we have the following multivariate model: r, = a^ + ^^r^, + e, (2)

where E{ti) = 0, var(e,) = E, a^ is the A'^vector of a,>n's {i = 1, . . ., N), and /3^ is the N-vectOT of i3,vn's defined as cov(r,,r^)/var(r,n). e, is independent of r^i, and E is an full A'^ X Af covariance matrix assumed to be positive definite. An unbiased estimator of E is computed from cross-products of OLS residuals with T-2 in the denominator. It is well known that if portfolio m is mean-variance efficient then the following condition must be true:

EMPIRICAL EVALUATION OF THE ICAPM

731

(r,) = ^^, E(r,^,)

(3)

which together with (2) implies that the null hypothesis for mean-variance efficiency is o!^ = 0. Cibbons, Ross and Shanken (1986) develop a statistical procedure in order to test the joint significance of the estimate values of a^ across all Af equations. It should be realized that (2) is a system that can be estimated using OLS for each individual (i = 0, . . ., N) equation. The statistic suggested is given by:

d - [r/(i + el)] :. -'

(4)

where, 6^ = TJs^. is the time-series mean of r^, and ^^ is the standard deviation of the portfolio index excess return during the estimation period. From multivariate statistics, [(7"-A'-l)/A'^(7"-2)]Q,has an exact small sample i^ distribution with degrees of freedom T ^ and (T-N-i).^ On the other hand, V the empirically implemented ICAPM can be written as: r, = &k + &k rkt + r), (5)

where, 5^ is the TV-vector of 6,i's (z = 1, . . . ., A^), ^i, is the A^ X 2 matrix of fo's, r^, = irmi,r/,,)', E{r],) = 0, var(77,) = V, and r^, is the excess return on the hypothetical hedging portfolio. Following the result discussed above, a necessary condition for mean-variance efficiency of the linear combination between r^, and r/,/ is dj^ = 0, for all t = 1 A^. To test the null hypothesis, the following statistic may be used:

d* = Til + rift-'Ft)-' 8l F-' 6,

(6)

where, 7^ is a vector of sample means for r^i, Cl is the sample covariance matrix for r^i, 'St is a vector of the OLS estimates for 6^ based on the N regression equations in (5), and V is the unbiased covariance matrix of V. It can be shown that [(T-N-k)/N{T-k-l)] Q* has an exact /^ distribution with T and T-N-k degress of freedom. The expression (6) will be used in the empirical V application. Alternatively, a cross-sectional test may be performed. Let us write the ICAPM in the following way: E = XT (7)

where X = {\,,:&^:&,), T = (70, 7i, 72)' and E = (r,). Note that from (5), we get an A^-vector of OLS estimators of/3^ and /3/,; and therefore X = (iN'-^m ' $/,) is actually used. Let 7be the time series mean of the excess return vector r,. If we run a GLS cross-sectional regression of Fon X, with covariance matrix V, we get: ^ = F - Xf where, (8)

f = (i'F-'i-)-'i-'F-' r.

(9)

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It may be argued that the cross-sectional test allows a more explicit test of linearity between risk and return than the time-series test. Unfortunately, as is well known, an exact small-sample test is not available given the estimation error in the independent variables. In the context of the Capital Asset Pricing Model (CAPM), Shanken (1985) proposes the following statistic to be used in testing (7): Q' = Te'V-^e. (10)

It can be shown that the exact distribution of Q' is bounded above by the central T'^{N-3,T-2).'^ This means that when we accept the null hypothesis, we would actually have a small-sample result, assuming normality. The statistic reported in the empirical application is approximately distributed as F{N-3,T-N + 2) and is given by (l'[{T-N + 2)/{N-3){T-2)].

THE DATA Data necessary to compute monthly returns for a period of eighteen years were collected. The eighteen year period starts in January 1967, and ends in December 1984. This means that a total of 216 monthly returns are available. Given that the Spanish Stock Exchange is a relatively thin equity market, monthly observations were preferred to observations over a shorter interval of time. The use of daily or weekly returns would have reduced considerably the number of securities in the sample. It should be taken into account that a small number of stocks account for an important percentage of the total trading volume, and that a substantial number do not trade regularly enough to provide reliable daily or weekly returns. The final sample is composed of 160 stocks.^ During most of the period covered by this paper, there were three major stock exchanges. Data on prices for shares trading on more than one stock exchange were obtained from the exchange on which the share had the highest trading volume. The returns on all securities in the sample were used to compute an estimate of the monthly return on the market portfolio. A value-weighted market index was calculated, where the weights are the market values of each security at the end of the preceding year. On the other hand, given that Spain did not have short-term government securities during most of the period covered by this research, the riskless rate was based on lending rates offered by financial institutions. Although these rates were not insured, the assumption seems to be a reasonable approximation. Treasury Bills sold by auction and priced at a discount were traded for the first time in 1982. Assets with hedging possibilities for the investor include long term government securities and gold. Unfortunately, before 1978, the primary market for bonds was highly regulated. The economic authorities had total

EMPIRICAL EVALUATION OF THE ICAPM

733

control over the timing of the issues and the level of its interest rates. Moreover, the conditions which the issues had to meet in order to qualify; i.e., to be eligible for investment by the savings banks, were perfectly defined. This implies serious difficulties for non-qualified bonds, since individual investment in fixed income securities represented a very small amount. At the same time, the secondary market for government securities reached a very low percentage out of the total value of the market. Due to the extreme regulations imposed by the authorities, this low trading volume refiected the freezing of most outstanding public debt in the portfolios of financial institutions. For these reasons, market data for long/medium term government securities were collected only from January 1979 to December 1984. On the other hand, the return on gold was based on the London Stock Exchange Gold Index which is reported in dollars per ounce. There is no gold trading on the Madrid Stock Exchange. However, an index in pesetas per gram computed from the London Gold Index is available. Data cover the period between January, 1967, and December, 1984. Both indexes will be used in the empirical application. It should be taken into account that such a hedging asset would have negative correlation with interest rates and absence of correlation with the market return. Finally, and given the methodology proposed, an inversion of the full NxN covariance matrix is required. At the same time, A^ must always be less than T. Therefore, some aggregation of data is needed. Gibbons, Ross and Shanken (1986) point out that, for a given set of A'^assets, the multivariate test described in the previous section is invariant to how grouping is performed. In fact, it would be plausible to construct A^ portfolios with very little dispersion in betas ? with no impact on the power of the test statistic. In the present case, for each year, the number of securities with complete data was observed. These securities were ranked according to their market value at the end of the preceding year. This ranking was maintained throughout the year, and ten equally weighted portfolios with approximately the same number of securities were obtained. Hence, A'^ is equal to 10, where portfolio one contains the smallest firms and portfolio ten the largest.

EMPIRICAL RESULTS

Before testing the ICAPM, it was decided to provide some additional empirical evidence on the traditional form of the asset pricing model. The efficiency of the value-weighted market portfolio index was tested using the exact F test proposed by Gibbons, Ross and Shanken (1986). Rubio (1988) already pointed out that mean-variance efficiency of the value-weighted index between 1963 and 1982 is rejected at the 0.005 level.'' In this work, the full period, January 1967, to December 1984, was divided into three six-year sub-periods; 1967-72, 1973-78, and 1979-84. The

734

RUBIO

multivariate test described earlier was applied to each of the sub-periods and to the full eighteen year period. The empirical results are reported in Table 1. As expected, given the previous available evidence, mean-variance efficiency of the value-weighted index is rejected with an overall p-value of 0.002. It is interesting to note that mean-variance efficiency cannot be rejected during 1967-72, although it is clearly rejected during 1973-78 and 1979-84. As argued by Gibbons, Ross and Shanken (1986), rejection of the null hypothesis has a nice intuitive interpretation. The statistic used in this application provides a measure of the distance between the slope (through the origin) of the ex post efficient frontier and the slope of the line (from the origin) through the stock market index employed in the application. When this distance is too large, the statistic given by expression (4) would reject the null hypothesis. Given the weak evidence regarding the traditional CAPM, it seems reasonable to test more sophisticated forms of asset pricing. As pointed out in the introduction, Merton's ICAPM might be a potentially good description of security returns.^ Of course, it becomes necessary to duplicate Merton's hypothetical hedging portfolio. The validity of the proposed proxies was investigated by estimating the correlation coefficient between a time-series of the riskless rate, the market return, and a time-series of returns on each of the chosen proxies. The results are contained in Table 2. The evidence suggests that both proxies, gold and long/medium term government bonds, are practically uncorrelated with market returns. Unfortunately, they are positively correlated with the riskless rate. On the other hand, the correlation coefficients are quite low. In particular, between 1979 and 1984, the government bond index presents a correlation of 0.08 with the assumed state variable. It is clear, at least on an ex post basis, that these proxies would not provide perfect hedging possibilities against unfavorable movements in the opportunity set as described by the riskless rate. However, they present potential diversification benefits given the low correlation coefficient. These results should not be surprising. In practice, there is an enormous difficulty in finding assets or portfolios which satisfy the theoretical characteristics of Merton's hedging security. This lack of appropriate proxies complicates the objective to ascribe Merton's ICAPM with empirical content. Empirical results for the time-series test of the ICAPM are provided in Table 3. The statistic employed is given by expression (6). Linearity between expected return, risk and the degree of covariability of portfolio returns and gold is rejected, both in dollars and pesetas, during the sub-periods 1973-78, 1979-84 and for the full period 1967-84. The overall p-values for the gold index in pesetas and dollars are 0.003 and 0.001 respectively. There exists a surprising similarity between the results obtained by imposing the traditional CAPM and the results reported in Table 3. It seems, at least when gold is used as the hedging asset, that the empirically implemented ICAPM does not provide a more reasonable description of security returns than the CAPM. A slighdy superior performance of the model is reached when the hedging

EMPIRICAL EVALUATION OF THE ICAPM Table 1

735

Efficiency Test of the Value-Weighted Portfolio Index Using Monthly Data Regressions based on 10 market-value sorted portfolios: where, r,, is the excess return on portfolio ; and r^i is the excess return on the value-weighted market portfolio index. Null hypothesis: ,, = 0, V, = 1, . . ., 10

F = J^{T-N-iyNiT-2)] a where a ^ [77(1 + Ol)] K ^ - ' S,

and e^ = r^/s^. Sub-periods F(10,61) (/(-value) F(10,205) (/)-value) 1967-72 1.569 (0.138) _ 1973-78 2.509 (0.013) _ 1979-84 2.909 (0.005) _ 2.885 (0.002) 1967-84

Table 2 Correlation Coefficients among Government Bond Index, Cold, Market Portfolio Index and Riskless Rate (1967-1984)
Correlation Coefficients Market Return Riskless Rate

Gold (dollars) -0.011 0.100 1

Gold (pesetas)

Gvt. Bond Index*

Market Return Riskless Rate Gold (dollars) Gold (pesetas) Gvt.Bond Index

0.181 1

-0.021 0.169 0.929 1

-0.022 0.082 -0.136 -0.176 1

* Series available for the period 197984 only.

asset is assumed to be the government bond index. The/7-value equals 0.024. This is somewhat higher than the /(-value under gold returns. It is also interesting to indicate that ^^ reflects the degree of protection against unfavorable changes in the opportunity set provided by the security. As long as there is a negative correlation between the hedging asset and the state variable, a positive |8^ should be an indication of protection against changes

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RUBIO

Table 3 Exact F Tests of the Intertemporal Capital Asset Pricing Model Using Monthly Data
Regressions based on 10 market-value sorted portfolios:
'./ = h + fiim {''ml) + 0ih {''hi) + Vii

where, r,, is the excess return on portfolio i, r^^ is the excess return on the valueweighted market portfolio index and r/,i is the return on the hedging portfolio in excess of the riskless rate. Null hypothesis: 1,^ = 0, V, = 1, . . . 10 F = l{T-N-k)/N(T-k-l)] d', and k = 2. Sub-periods 1967-72 Gold Pesetas F( 10,60) (/)-value) F(10,204) (/)-value)
Gold Dollars

where Q* = T{\ + r^' fl-' r^)-' 1^ F"' 6^ 1973-78 2.495 (0.014) 1979-84 0.003 (0.003) 2.825 (0.003) 1967-84

1.525 (0.153)

F(10,60) (/)-value) F( 10,204) (/i-value)

1.493 (0.165)

2.485 (0.015)

3.113 (0.003) 3.053 (0.001)

Government Bond Index'' /="(10,60) N.A. (/)-value)

N.A.

2.279 (0.024)

N.A.

^ Series available for the period 197984 only.

in the riskless rate. In the present case, given the positive correlation between the interest rate and the government bond index (or gold), a negative |3^ would imply a good degree of protection of the security. When the government bond index was used as a proxy, the average /3^ across the ten portfolios was 0.471. On the contrary, when gold was imposed, the average /3^ was 0.036. This again seems to imply that the government bond index is playing a closer role than gold in behaving as a hedging asset. Empirical results from cross-sectional tests are reported in Table 4. Linearity for both gold in pesetas and the government bond index is rejected. As mentioned earlier, the reported /?-values are just approximations to the true /)-values. For gold, none of the three coefficients are statistically different from zero.^ In the case of the government bond index, ^Q and y\ are not different from zero. As previously documented by Rubio (1988), Spanish investors are not significantly compensated for bearing non-diversifiable risk. Between 1979

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737

Table 4 Approximate F Tests of the Intertemporal Capital Asset Pricing Model Using Monthly Data
Cross-sectional regressions based on 10 market-value sorted portfolios. Null hypothesis; E = XT, where X = (1;^; &: (3/,), T = (70, 7 b 72)' ^"d E = E{ri). ri is the N-vectov of excess return. F = Q_' (T-N_+2.)/{N-3){T-2), where Q' = Te' K"' e and e = T X T.
Period

1967-84
4.101 (0.0003) -0.00601 (0.00758) 0.00997 (0.00825) 0.01100 (0.02104)

Period

1979-84''
3.425 (0.004) -0.00900 (0.00777) 0.01393 (0.01015) -0.01110* (0.00415)

Gold Pesetas F(7,208) (/7-value)

7-0

Government Bond Index F(7,64) (/(-value)

7-0

(std. error)
7l

(std. error)
7l

(std.error)
72

(std. error)
72

(std.error)

(std. error)

' Series available for the period 197984 only. * Means that the estimated coefficient is more than two standard deviations from

and 1984, 71 equals 1.39 percent with a ^value of 1.372.^ On the other hand, 72 is negative and statistically different from zero. This might be interpreted in the sense that the greater the protection a risky asset provides against changes in the state variable, the lower the return the investor is expected to earn. It may therefore be concluded that the empirically implemented ICAPM has not significantly improved the performance of the CAPM in explaining risky returns. Unfortunately, the failure of the model might be due to the practical impossibility of finding an adequate hedging asset. More research in this direction is largely justified."' As Shanken (1987b) points out, multivariate i^ tests implicitly impose constant (over time) betas and residual covariance matrix. Moreover, the disturbance term is assumed to be normally distributed and serially independent. The first problem may be partially solved by assuming that betas depend linearly on the state variable and on a dummy variable which equals one in January and zero otherwise:
b,, + bi, Rf + b,2 J a n bl + b'^ Rf + 6*2 J a n

(11)

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RUBIO Table 5

Exact F Tests of the Intertemporal Capital Asset Pricing Model Using Monthly Data Regressions based on 10 market-value sorted portfolios with betas depending on state variables:
Ul = ^ik + ^im (rml) + ^,7, i'-hl) + Vii

where each of the betas, /3,^ and /3,7,, is assumed to be linear in the riskless rate and a dummy variable, Jan, which equals one in January and zero otherwise, r,, is the excesss return on portfolio i, r^, is the excess return on the value-weighted market portfolio index and r/;, is the return on the hedging portfolio in excess of the riskless rate. Null hypothesis: l.t = 0, V,- = 1, . . . 10 F = [{T-N-k)IN{Tk-\)] and A = 6. : Sub-periods Gold Pesetas /="(10,56) (p-value) f(10,200) (/)-value) F(10,56) {p-vaXxie) 1967-72 1.084 (0.390) Q*, where (2* = T{\ + ^ Cl'^ 7,,)-^ Sj, f^' 6^

1973-78
2.284 (0.025)

1979-84
2.958 (0.005)

1967-84

2.756 (0.003) N.A. N.A. 2.092 (0.040) N.A.

Government Bond Index"

Series available for the period 197984 only.

where, Rf stands for the rate of return of the riskless asset. To consider the month of January as an additional state variable does not imply the necessity of incorporating a nev^f hedging asset. On the other hand, this is clearly justified given that the nature of the price formation in January seems to be different from the rest of the year." January, is not only the month in which investors have been rewarded for accepting risk, but it is also the month in which small firms clearly outperformed the rest of the market. The empirical procedure is similar to the one employed in getting the results of Table 3. However, k in this case equals six. The results are provided by Table 5. As in Table 4, gold in pesetas and the government bond index are assumed to be the hedging assets. The overall p-value for gold is similar to the one obtained earlier. However, the performance has slightly improved in each of the sub-periods. On the other hand, when the government bond index is assumed, the /)-value increases from 0.024 and 0.040. This might indicate some seasonality in the beta coefficients, or alternatively that they tend to vary with the level of the interest rate. Consequently, we may conclude that when

EMPIRICAL EVALUATION OF THE ICAPM

739

non-constant betas are allowed, the empirically implemented ICAPM offers a more adequate description of security returns than the traditional CAPM, at least when the government bond index is employed as the hedging asset.

TESTING ASSET PRICING MODELS WITH CHANGING CONDITIONAL MOMENTS

This section replicates, with Spanish data, Shanken's (1987b) asymptotic methodology to investigate the empirically implemented ICAPM in the presence of conditional residual heteroskedasticity. In this case, it will be allowed the intercepts, 6,/., as well as the stock market and bond market betas to change linearly with the level of interest rates and with monthly seasonality. Hence, the intercept may be written as: 5,t = a,o + an Rf + a,-2 Jan (12)

and a regression with nine independent variables will be performed. Under the null hypothesis that 6,^ = 0 for all assets, the coefficients a,o, a,i and a,2 must also be zero for every portfolio. On the one side, the presence of residual heteroskedasticity does not permit to implement the exact i^ tests used in the previous section. On the other hand, to allow the intercept to vary with the level of the state variable might provide additional evidence on the reasons behind the strong rejection of the model. Heteroskedasticity-consistent standard errors are obtained using White's (1980) consistent covariance matrix estimator. This estimator has the advantage of not relying on a specific model of the structure of the heteroskedasticity. It should be pointed out that, in some cases, the standard errors were much larger than the OLS errors. Table 6 contains the statistical significance of the three components of the intercept, stock market betas and government bond betas for each size portfolio. The mciximum, in absolute value, ^-statistic presented in Table 6 allows, as Shanken (1987b) points out, a test of the joint hypothesis that all coefficients on a given explanatory variable are zero. The reported /;-values are an upper bound on the probability of obtaining a maximum ^-statistic as large as that observed.''^ As expected, the constant component of stock market betas is highly jointly significant. At the same time, it is not possible to reject the hypothesis that stock betas are independent of a January seasonal, although they tend to vary with the level of the riskless rate. On the other hand, the constant component of government bond betas is not statistically different from zero. They are, however, independent of the level of the risk free rate, and there is some evidence of a January seasonal. The empirical results regarding the components of the intercept provide additional light on the rejection of the model. The January seasonal component

740

RUBIO

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EMPIRICAL EVALUATION OF THE ICAPM

741

is jointly significant. This is particularly relevant for the three smallest portfolios. The estimated coefficient of the smallest firms equals 2.64 percent per month, whilst the coefficient for the largest firms is negative 0.84 percent per month. Of course, this justifies the use of a January seasonal as the state variable, and it is also consistent with the previous empirical evidence reported by Rubio (1987). Moreover, there exists significant evidence of an interest rate component in the intercepts.'^ Finally, Table 7 presents evidence of conditional disturbance heteroskedasticity. Again, the residual variance for each portfolio from the previous ten time series regressions is assumed to be linear in the riskless rate and a dummy variable, Jan, which equals one in January and zero otherwise.

Table 7
Residual variance for each portfolio is assumed to be linear in the riskless rate and a dummy variable, Jan, which equals one in January and zero otherwise. Regressions of the squared residuals from Table 5 on a constant, the riskless rate and Jan. Heteroskedasticity-consistent standard errors are in parentheses. The long term government bond index used as the hedging portfolio, 197984.
Estimated Coefficient

Fortfoiio i MV 1 MV 2 MV 3 MV 4 MV 5 MV 6 MV 7 MV 8 MV 9 MV 10 Max \t (^-value)

Constant

Rf
0.16020 (0.15253) 0.25442 (0.18588) 0.12264 (0.17780) 0.31752 (0.19477) 0.16495 (0.14589) 0.29921' (0.13379) 0.31311* (0.10204) 0.17358* (0.07900) 0.12008* (0.04847) 0.55045* (0.16155) 3:407 (0.011)

Jan
0.00025 (0.00156) -0.00154* (0.00061) -0.00027 (0.00063) -0.00116 (0.00086) -0.00041 (0.00058) -0.00105 (0.00054) -0.00030 (0.00075) 0.00135 (0.00131) -0.00052* (0.00021) 0.00245 (0.00198) 2.525 (0.138)

0.00164 (0.00112) 0.00071 (0.00105) 0.00116 (0.00104) 0.00040 (0.00109) 0.00040 (0.00079) -0.00062 (0.00063) -0.00041 (0.00051) -0.00012 (0.00050) -0.00008 (0.00025) -0.00234* (0.00083) 2.819 (0.062)

* means that the estimated coefficient is more than two standard deviations from zero.

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RUBIO

The interest rate component of residual variance is statistically jointly significant. It is interesting to note that this component is individually only significant for the five largest portfolios,'* and that the estimated coefficient is positive for every portfolio. There is no evidence of a January seasonal in residual variance.
CONCLUSIONS

Given the past empirical evidence on the traditional forms of asset pricing, this work reports exact multivariate tests on Merton's (1973) ICAPM using Spanish data. The model is strongly rejected assuming either gold or the government bond index as hedging assets. The performance of the model is slightly improved when non-constant stock market betas and government bond betas are allowed. On the other hand, using an asymptotic methodology proposed by Shanken (1987b), the IGAPM, in the presence of conditional residual heteroskedasticity, is strongly rejected particularly during the month of January when the so called 'January effect' is observed. Stock market betas vary with the level of the interest rate, and government bond betas are found to shift during January. Residual variance also change with the level ofthe interest rate. Of course, it is not clear that the value-weighted stock market index and the government bond index or, alternatively, the gold index, capture adequately the variability ofthe fundamental aggregate; i.e., the marginal utility of consumption. Finally, it seems clear that the Spanish capital market is not sufficiently rich, so that the choice ofthe relevant state variable or the hedging assets might not reasonably correspond to theoretical constructs.

NOTES
1 See Rubio (1988). 2 The Spanish capital market is in clear need of empirical research. Unlike the US market where there has been an extraordinary amount of empirical research on the price formation of financial assets, the Spanish market has experienced little empirical research of this type. This paper provides further evidence regarding the return generating process in Spain. In this sense, it complements Alonso, Rubio and Tusell (1987) and Rubio (1988). Moreover, the applicability of modern financial theory has received practically no attention in thin equity markets, where trading volume and market capitalization are relatively small. 3 What Gibbons, Ross and Shanken (1986) actually show is that the statistic has a noncentral /^distribution. Their result gives the conditional distribution ofthe statistic under the null hypothesis; i.e., the noncentrality parameter equals zero, as well as the alternative hypothesis; i.e., the noncentrality parameter different from zero. 4 See Shanken (1985). 5 In 1984, the market capitalization ofthe Madrid Stock Exchange reached $21,392 millions. This represented 0.56 percent out ofthe total world capitalization. The market capitalization of the New York Stock Exchange and the London Stock Exchange was $1,529,459 and $236,403 millions respectively. The ratio of volume of transactions to market capitalization has been around 10 percent during the eighties. This is considerably less than in New York and London, where, in 1984, these ratios reached 50 percent and 20 percent respectively. 6 Multivariate cross-sectional tests are run in Rubio's (1988) paper. Moreover, he shows that

EMPIRICAL EVALUATION OF THE ICAPM

743

7 8 9 10

11 12 13 14

the Sharpe-Linter equilibrium model and the joint hypothesis that the Spanish value-weighted stock index explains more than 25 percent of the variability of the true market portfolio can be rejected from 1963 to 1982. Unfortunately, in Spain, consumption data are not available frequently enough to test the Consumption Capital Assets Pricing Model (CCAPM). Similar results were found when the cross-sectional GLS regression was run between 1979 and 1984. Note, however, that if rejection ofthe null hypothesis occurs, the usual interpretation ofthe t-statistic is inappropriate. It was suggested by J. Urrutia of the Instituto de Economia Pubiica that real estate and construction firms should be a reasonable proxy for the hedging asset. Although, these companies had a low negative correlation with the riskless rate, the correlation with the market return was highly positive. See Rubio (1988). The reported p-value equals the number of parameters in the joint test (10 portfolios) times the usual two-sided p-value. See Shanken (1987b) for details. Similar results are obtained when gold in pesetas is used as the hedging asset. When gold in pesetas was used, nine out ofthe ten portfolios presented evidence that the residual variance varied with the level of the interest rate.

REFERENCES
Alonso, A., G. Rubio and F. Tusell (1987), 'Asset Pricing and Risk Aversion in the Spanish Stock
M a r k e t ' , Southern European Economics Discussion Series (SEEDS), No. 53 (1987).

Gibbons, M., S. Ross and J. Shanken (1986), 'A Test of the Efficiency of a Given Portfolio', Research Paper 853 (Stanford Univeristy, 1986). Merton, R. (1973), 'An Intertemporal Capital Asset Pricing Model', Econometrica 41 (1973), pp. 869-887. Roll, R. (1977), A Critique of the Asset Pricing Theory's Tests; Part I: On Past and Potential Testability of the Theory', Journat of Financiai Economics 4 (1977), pp. 129176. Rubio, G. (1988), 'Further International Evidence on Asset Pricing: The Case ofthe Spanish Capital Market', Joumai of Banking and Finance, 12 (1988), pp. 221242. Shanken, J. (1985), 'Multivariate Tests ofthe Zero-Beta CAPM' Joumai of Financial Economics 14 (1985), pp. 327-348. (1987a), 'Multivariate Proxies and Asset Pricing Relations: Living with the Roll Critique',
Journal of Financial Economics 18 (1987), pp. 91 110.

. (1987b), 'The Intertemporal Capital Asset Pricing Model: An Empirical Investigation', Mimeo (University of Rochester, 1987). White, H. (1980), 'A Heteroskedasticity-Consistent Govariance Matrix Estimator and a Direct Test for Heteroskedasticity', Econometrica 48 (1980), pp. 817-838.