An Investment-Growth Asset Pricing Model

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Abstract
In this paper we present a simple model where asset returns are functions of multiple investment growth rates. The model is tested for its ability to price the 25 Fama-French portfolios using the Generalized Methods of Moments (GMM) methodology, as well as Fama-MacBeth cross-sectional regressions. Comparisons on the basis of several metrics with other models, such as the CAPM, the Fama-French (1993) model and Cochrane's (1996) model, reveal that it consistently outperforms the CAPM and Cochrane's model. It also outperforms the Fama-French model in several tests. Our model can explain a significantly larger proportion of the cross-sectional variation in the 25 Fama-French portfolios than the Fama-French model does. Specification tests in the context of GMM and the Fama-MacBeth regressions show that in the presence of the investment growth factors included in our model, the size and book-to-market characteristics lose their ability to explain asset returns. Our model is successful in pricing size- and book-to-market- sorted portfolios, although it includes exclusively macroeconomic variables as factors.