What is the Intertemporal Asset Pricing Model (ICAPM)?
The Intertemporal Asset Valuation Model (ICAPM) is a consumption-based asset valuation model (CCAPM) that assumes investors hedge risky positions. Nobel Laureate Robert Merton introduced ICAPM in 1973 as an extension of the Capital Asset Valuation Model (CAPM).
CAPM is a financial investment model that helps investors calculate the potential returns on investments based on the level of risk. ICAPM extends this theory by allowing more realistic investor behavior, particularly with respect to the desire of most investors to protect their investments from market uncertainties and to build dynamic portfolios that hedge against risk.
Key points to remember
- Investors and analysts use financial models, which in number represent one aspect of a company or a security, as decision-making tools in determining whether to invest.
- Nobel Laureate Robert Merton created the Intertemporal Capital Asset Pricing Model (ICAPM) to help investors deal with risk in the market by creating portfolios that hedge against risk.
- The word âintertemporalâ in ICAPM recognizes that investors typically participate in markets for several years and are therefore interested in developing a strategy that evolves as market conditions and risks change over time.
Understanding the Intertemporal Asset Pricing Model (ICAPM)
The goal of financial modeling is to represent in numbers an aspect of a company or a given security. Investors and analysts use financial models as decision support tools to determine whether to invest.
CAPM, CCAPM, and ICAPM are all financial models that attempt to predict the expected return of a security. A common criticism of CAPM as a financial model is that it assumes that investors are concerned about the volatility of an investment’s returns to the exclusion of other factors.
However, ICAPM provides additional precision over other models by considering how investors participate in the market. The word âintertemporalâ refers to investment opportunities over time. It takes into account the fact that most investors participate in the markets for several years. Over longer periods of time, investment opportunities may change as risk expectations change, leading to situations in which investors may wish to hedge.
Sample Intertemporal Asset Pricing Model (ICAPM)
There are many microeconomic and macroeconomic events that investors may want to use their portfolios against to protect themselves. Examples of these uncertainties are many and could include such things as an unexpected downturn in a specific business or industry, high unemployment rates, or heightened tensions between nations.
Certain investments or asset classes may historically perform better in declining markets, and an investor may consider holding these assets if a downturn in the business cycle is expected. An investor who uses this strategy may hold a hedging portfolio of defensive stocks, those which tend to outperform the broader market in times of economic downturn.
An ICAPM-based investment strategy therefore takes into account one or more hedge portfolios that an investor can use to deal with these risks. ICAPM covers multiple time periods, so multiple beta coefficients are used.
While ICAPM recognizes the importance of risk factors in investing, it does not fully define what these risk factors are and how they affect the calculation of asset prices. The model indicates that these factors affect how much investors are willing to pay for assets, but do little to address all of the risk factors involved or to quantify how much they influence prices. This ambiguity has led some analysts and academics to conduct research on historical price data to correlate risk factors with price movements.