Intertemporal Capital Asset Pricing Model - ICAPM

DEFINITION of 'Intertemporal Capital Asset Pricing Model - ICAPM'

A financial model that takes into account major sources of risk when optimizing consumption over a period of time. The intertemporal capital asset pricing model (ICAPM) assumes that security returns are normally distributed over multiple time periods, and that all future consumption will be funded by security returns.

ICAPM was described by Nobel laureate Robert Merton in 1973.

BREAKING DOWN 'Intertemporal Capital Asset Pricing Model - ICAPM'

ICAPM is a consumption-based asset-pricing model, and it goes a step further than CAPM in taking into account how investors participate in the market. Most investors do not participate in financial markets for one year, but instead for multiple years. Over longer time periods, investment opportunities might shift as expectations of risk change, resulting in situations in which investors may wish to hedge. For example, an investment may perform better in bear markets, and an investor may consider holding that asset if a downturn in the business cycle is expected.

ICAPM uses mean-variance analysis to create normal distribution of consumption risk over time. Because ICAPM covers multiple time periods, multiple beta coefficients are used to determine how many security concerns covary with a basket of risky securities.

A criticism of ICAPM is that it assumes that consumer expectations are homogenous, meaning that it cannot take into account individual risk preferences.

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