What Is Intertemporal Capital Asset Pricing Model (ICAPM)?
The Intertemporal Capital Asset Pricing Model (ICAPM) is a consumption-based capital asset pricing model (CCAPM) that assumes investors hedge risky positions. Nobel laureate Robert Merton introduced ICAPM in 1973 as an extension of the capital asset pricing model (CAPM).
CAPM is a financial investing model that assists investors in calculating potential investment returns based on risk level. ICAPM extends this theory by allowing for more realistic investor behavior, particularly regarding the desire most investors have to protect their investments against market uncertainties and to construct dynamic portfolios that hedge against risk.
- Investors and analysts use financial models—which represent in numbers some aspect of a company or security—as decision-making tools when determining whether to make an investment.
- Nobel laureate Robert Merton created the intertemporal capital asset pricing model (ICAPM) to help investors address risks in the market by creating portfolios that hedge against risk.
- The word "intertemporal" in ICAPM acknowledges that investors typically participate in markets for multiple years and are thus interested in developing a strategy that shifts as market conditions and risks change over time.
Understanding Intertemporal Capital Asset Pricing Model (ICAPM)
The purpose of financial modeling is to represent in numbers some aspect of a company or a given security. Investors and analysts use financial models as decision-making tools when determining whether to make an investment.
CAPM, CCAPM, and ICAPM are all financial models that attempt to predict the expected return on a security. A common criticism of CAPM as a financial model is that it assumes investors are concerned about an investment's volatility of returns to the exclusion of other factors.
ICAPM, however, offers further precision over other models by taking into account how investors participate in the market. The word "intertemporal" refers to investment opportunities over time. It takes into consideration that most investors participate in markets 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.
Example of Intertemporal Capital Asset Pricing Model (ICAPM)
There are many microeconomic and macroeconomic events that investors may want to use their portfolios to hedge against. Examples of these uncertainties are numerous and could include such things as an unexpected downturn in a company or within a specific industry, high unemployment rates, or increased tensions between nations.
Some investments or asset classes may historically perform better in bear 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 hedge portfolio of defensive stocks, those that tend to perform better than the broader market during economic downturns.
An investment strategy based on ICAPM, therefore, accounts for one or more hedging portfolios that an investor may use to address these risks. ICAPM covers multiple time periods, so multiple beta coefficients are used.
While ICAPM acknowledges the importance of risk factors in investing, it does not fully define what those risk factors are and how they impact the calculation of asset prices. The model says these factors affect how much investors are willing to pay for assets, but does little to address all the risk factors involved or quantify to what extent they influence prices. This ambiguity has led some analysts and academics to conduct research on historical pricing data to correlate risk factors with price fluctuations.