Pacific-Basin Finance Journal: Han Zhang

Pacific-Basin Finance Journal 68 (2021) 101601
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Pacific-Basin Finance Journal

journal homepage: www.elsevier.com/locate/pacfin
An inflation-based ICAPM in China

Han Zhang
Business School, Nankai University, 121 Baidi Road, Nankai District, Tianjin 300071, China
A R T I C L E I N F O A B S T R A C T
JEL classification: There is a consensus regarding the weak link between China’s stock market and its macro-
E31 economy. In contrast, this paper shows that inflation has a strong pricing ability for China’s
E44 stock returns. We develop a two-factor intertemporal capital asset pricing model (ICAPM) of
G11
Merton (1973), in which inflation is a state variable. The theoretical results show that the mar
G12
G15
ginal wealth value is high, when the economy is experiencing deflation or hyperinflation. The
G18 empirical results show that the price of inflation risk is significantly negative. The inflation-based
O16 ICAPM outperforms the three- and five-factor asset pricing models of Fama and French (1993,
O53 2015), especially at stock-level. Furthermore, inflation satisfies the restrictions on time series and
P20 cross-sectional behavior of state variables, implying that the model is consistent with ICAPM.
P34
Keywords:
Intertemporal CAPM
Cross-sectional of expected returns
Inflation risk
China’s stock market
1. Introduction
Although China’s stock market has emerged as the world’s second-largest, there is a consensus that it is separated from the
country’s macroeconomic conditions.1 Back in 2001, a famous Chinese economist Wu Jinglian compared China’s stock market to a
casino. Following Wu, Economist (2015) called this market a “crazy casino”. Allen et al. (2018) present statistical evidence to prove the
weak link between China’s stock returns and its GDP. It is generally believed that the low correlation between China’s stock market and
its macroeconomic conditions is due to several unique characteristics, such as a high proportion of retail investors, IPO suspensions,
split share structures, and trading restrictions imposed on foreign investors.2 Hence, a large body of literature focusing on China’s stock
market looks for pricing factors separate from the market itself.3 Cochrane (2005, Preface) calls this approach relative pricing. In
contrast, absolute pricing, a more ambitious approach, uses exposure to fundamental sources of macroeconomic risk to price assets.4 As
E-mail address: hanzhang@nankai.edu.cn.

1
See, e.g., Scholer (2015) in the Wall Street Journal, Holodny (2015) in the Business Insider, and Pham (2018) in the Forbes magazine.
2
Allen et al. (2009) and Allen et al. (2018) provide comprehensive reviews of China’s stock market and its financial and macroeconomic
environment. Carpenter et al. (2018) recently show that stock prices in China are closely related with firm fundamentals, contradicting a common
perception.
3
Such studies, among others, include Wang and Chin (2004), Wang and Xu (2004), Chen et al. (2010), Cheung et al. (2015), Hu et al., 2019, Guo
et al. (2017), Liu et al., 2019, Jiang et al. (2018), Pan et al. (2021).
4
Cochrane (2017) presents an explicit review of “macro-finance”, another expression of absolute pricing.
https://doi.org/10.1016/j.pacfin.2021.101601
Received 6 September 2020; Received in revised form 28 March 2021; Accepted 20 June 2021
Available online 29 June 2021
0927-538X/© 2021 Elsevier B.V. All rights reserved.
H. Zhang Pacific-Basin Finance Journal 68 (2021) 101601
far as we know, however, macro-based pricing remains underexplored in the context of China’s stock market. Unlike the previous
studies, this paper shows that an absolute pricing model using inflation as a state variable outperforms several popular relative pricing
models in China.
In this paper, we develop for China’s stock market a two-factor intertemporal capital asset pricing model (ICAPM) of Merton
(1973), in which the state variable is the natural logarithm of two-year price level growth, i.e., the logarithm of two-year inflation
(referred to simply as inflation hereafter). In fact, all shocks in midterm inflations (2–4 years) have strong pricing ability, shown in
Section 6. Considering the robustness of two-year inflation to different test portfolios and individual stocks, we choose it as a
representative. An equilibrium theoretical model we construct shows that the relationship between the marginal value function and
inflation is U-shaped. If Et(dπ) < (γ − 1)covt(dSm/Sm, dπ), where Et(dπ) is the conditional expected inflation growth, γ is the relative risk
aversion, and covt(dSm/Sm, dπ) is the conditional covariance between market return and inflation growth, then the factor risk price of
inflation is negative; i.e., increases in inflation are bad news. In China, the mean monthly growth of two-year inflation was approx
imately − 0.14%, and the correlation between the growth and market return was approximately 0 in the period between July 1995 and
June 2015. Hence, increases in inflation are bad news and thus raise the marginal wealth value of investors. In contrast, increases in
inflation are not bad news in the US. The mean monthly growth of inflation in the US is about 0, and the covariance between the growth
and market return is negative, implying that increases in inflation reduce the marginal value. This is one of main differences between
the two countries.
We compare the pricing power of the capital asset pricing model (CAPM) of Sharpe (1964) and Lintner (1965), the three- and five-
factor models of Fama and French (1993, 2015) (FF3F and FF5F), and our inflation-based ICAPM, measuring by the mean absolute
pricing errors (MAPE) and cross-sectional adjusted R2 (adj.R2). The empirical results show that the risk price of inflation shock is
significantly negative in cross-section. At portfolio-level asset pricing tests, the ICAPM outperforms CAPM and FF3F, but underper
forms FF5F; in contrast, the ICAPM outperforms other models at stock-level. Lewellen et al. (2010) suggest that using stock-level
regressions is an efficient method to evaluate models, but one must consider the error-in-variables (EIV) problems. Because the
betas are estimated by time-series regressions, the estimators of cross-sectional regressions of mean returns on betas are inconsistent
(Shanken, 1992). To modify the OLS inconsistent estimators, Jagannathan et al. (2010) give an N-consistent estimators when the
number of test stocks approaches infinity. We integrate the moments of time-series regressions, N-consistent cross-sectional regressions
of Jagannathan et al. (2010) and pricing errors into a generalized method of moments (GMM) framework of Hansen (1982). Hence, the
results of stock-level tests are robust to the EIV problems.
To consider the conditioning information in the models, we add managed portfolios, original asset returns multiplied by instrument
variables, into the test portfolio set. The instrument variables can forecast the asset returns. Cochrane (2005, Chapter 8) points out that
adding managed portfolios and proceeding with unconditional moments is equivalent to conditional models. After expanding the
scope of portfolios, we find that the results above are robust to the conditioning information.
We also use bootstrap simulation to test whether the results of cross-sectional point estimates reject the null hypothesis that the
asset pricing models are false. The simulation results show that, at portfolio-level, only the t-statistics of shock in inflation are sig
nificant at 1% confidence level, and the adj.R2 of FF5F and inflation-based ICAPM are significant at 5% confidence level. At stock-level,
all significant statistics are concentrated at the ICAPM.
Maio and Santa-Clara (2012) emphasize the consistency of time series and cross-sectional behavior of state variables. If a state
variable negatively affects forecast changes in aggregate wealth, its shock should result in a negative risk price in cross-section, and
vice versa. The reason is that increases in state variable that negatively forecast changes in aggregate wealth are bad news; meanwhile,
an asset paying more provides a hedge against the bad news. Hence, the price of that asset will be higher, and its expected return will be
lower than that of an asset that is uncorrelated with the state variable, resulting in a negative risk price for the shock of the state
variable. Maio and Santa-Clara (2012) run regressions of future aggregate returns and market volatility on state variables. Since the
market return cannot represent the aggregate wealth of representative agent, Boons (2016) choose the Industrial Production Index and
Chicago Fed National Activity Index representing macroeconomic activity as predicted variables. It is notable that the market return
reflects only the discount rate rather than the received cash flows. In other words, for a representative agent economy, a price bubble
increasing the agent’s wealth cannot lead to more consumption by the agent. Hence, Koijen et al. (2017) use dividend growth to
measure the investment opportunities’ set.
Based on the above, we run regressions of future aggregate dividend growth, market volatility and two macroeconomic activity
variables–power generation capacity (PGC) and economic climate index (ECI)–on inflation and the corresponding state variables of
Fama-French factors to test the consistency of the inflation-based ICAPM. Using the cross-sectional regression on covariances, we
estimate a significant and plausible relative risk aversion of 1.65 with a t-statistic of 3.51. Due to the negative risk prices, inflation
negatively forecasts dividend growth, PGC and ECI positively forecast long-run market volatility, which indicates that inflation is
consistent with the ICAPM. In contrast, the Fama-French factor models do not exhibit consistency. A bootstrap simulation of time series
regressions is considered to test whether a significant time series-based point estimate is due to sample selection. We observe that the
estimates, t-statistics and adj.R2 of inflation regressions reject the null hypothesis that the state variable cannot forecast investment
opportunities at the 5% confidence level.
The remainder of this paper is organized as follows. Section 2 constructs a two-factor ICAPM. Section 3 discusses the data and the
econometric approach. Section 4 compares the pricing ability of various models separately. Section 5 estimates the relative risk
aversion coefficients, and evaluates the consistency of pricing models with ICAPM. Section 6 compares two-year inflation with other
macro-related candidate state variables and inflation measures with other horizons. Section 7 summarizes the conclusions.
2
2. Two-factor ICAPM
There are N risky assets and a risk-free asset in perfectly elastic supply with a constant instantaneous rate of return r:
dBt
= rdt. (1)
Bt
The price of risky asset i evolves as a geometric Brownian motion,
dSi,t
= μi (π t )dt + σ i (πt )dzi , i = 1, …, N, (2)
Si,t
where dzi is a Wiener process and dzi and dzj for i, j = 1, …, N are independent; μi and σi are the mean and standard deviation,
respectively, of the instantaneous rate of return without dividends; and π is the inflation. All prices are real. Eq. (2) indicates that the
dynamics of real prices are nonetheless affected by inflation. We regard inflation as a state variable that evolves according to an
Ornstein-Uhlenbeck process
dπt = − ϕ(πt − μπ )dt + σ π dzπ . (3)
The covariance of dzi and dzπ is equal to σiπdt. The real wealth evolves according to the following dynamics:
∑N ( ) ∑N
D
dW t = (rW t − Ct )dt + ωi Wt μi + i,t − r dt + ωi Wt σi dzi , (4)
i=1
S i,t i=1
where C is consumption and ωi is the wealth weight of investing in asset i. According to Wachter (2013), the utility function Vt of
representative agent has a recursive form
[∫ ∞ ]
Vt = Et e− δs U(Cs , Vs )ds , (5)
t
where
( )
1
U(C, V) = β(1 − γ)V logC − log((1 − γ)V ) (6)
1− γ
Parameter β represents the rate of time preference, V represents the utility of a consumption stream, and γ represents the relative
risk aversion. We assume that β > 0 and γ > 1. The term (1 − γ)V is the argument of the logarithmic function, which means that utility V
is negative.
The representative agent maximizes his expected lifetime utility; thus, the value function J(W, π, t) are
[∫ ∞ ]
J(Wt , πt , t) ≡ max Et e− δs U(Cs , Vs )ds (7)
Cs ,ωi,s t
In equilibrium, J(Wt, π t, t) = Vt. Using Ito lemma, the value function J(W, π , t) satisfies a Bellman equation:
( ( ))
∑ N
Di,t 1 ∑N
− δt
0 = e U(Ct ) + Jt + JW rW t − Ct + ωi Wt μi + − r + JWW ω2i Wt2 σ2i
i=1
Si,t 2 i=1
(8)
1 ∑N
− Jπ ϕ(π t − μπ ) + Jππ σ 2π + JW π ωi Wt σi σπ σiπ .
2 i=1
We guess that the value function takes the form

1− γ
δt W
(9)
2
J(W, π, t) = e− ea+bπ+cπ ,
1− γ
where c ∕
= 0. Together with the utility function (6) and the conjecture of value function (9), the envelope condition implies that
UC = JW
W 1− γ a+bπ+cπ2 1 2
β(1 − γ) e = W − γ ea+bπ+cπ .
1− γ C
The solution is β = C/W. The constant consumption-wealth ratio arises from the assumption of unit elasticity of intertemporal
substitution.
Taking the solution of β, utility function (6), the conjecture of value function (9) and its derivatives with respective to t, W and π
into the Bellman Eq. (8) implies
3
Fig. 1. Second-order cross-derivative of value with respective to wealth JWπ and inflation π. The figure shows the JWπ as a function of monthly
∑
inflation π. The calibration parameters are set as follow: β = 0.012, γ = 3, ϕ = 0.8, μπ = 0.25%, σπ = 0.25%, iωiσ iσ πσiπ = 0.01, δ = 0.015, r = 0.25%,
( ) √̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅
∑N Di ∑
i=1 ωi W μi + Si − r = 0.74%, i ωi σ i = 8.48%.
2 2
( ) ( ))
a + bπ + cπ2 δ ∑ ( D 1 ∑
0= β logβ − − + r− β+ ω i μi + i − r − γ ω2i σ2i −
1− γ 1− γ i
Si 2 i
(10)
( )
ϕ(π − μπ )(2cπ + b) 1 σ 2π 4c2 π2 + 4bcπ + b2 + 2c ∑
+ + (b + 2cπ) ωi σi σ π σiπ .
1− γ 2 1− γ i
Gathering terms of π2 gives
βc 2ϕc 2σ 2π c2
− − + = 0.
1− γ 1− γ 1− γ
Because we assume that c is nonzero,
β + 2ϕ
c= . (11)
2σ2π
Gathering terms of π gives
βb (b − 2cμπ )ϕ 2σ 2π cb ∑
− − + + 2c ωi σ i σ π σ iπ = 0,
1− γ 1− γ 1− γ i
which implies that

( )
∑ β + 2ϕ
b= − μπ ϕ + (1 − γ) ωi σ i σ π σ iπ . (12)
i ϕσ2π
Gathering constant term implies that

( ( )) ∑
∑ Di 1
a = (1 − γ)βlogβ − δ + (1 − γ) r − β + ωi μi + − r − γ(1 − γ) ω2i σ2i + ϕμπ b+
i S i 2 i
(13)
( )
σ 2π b2 + 2c ∑
+ b(1 − γ) ωi σi σ π σ iπ .
2 i
The first-order condition of (8) with respect to asset weight gives

Di,t
μi + − r = γωi σ 2i + γπ,t σi σ π σiπ , (14)
Si,t
WJWW JWπ
where γ ≡ − JW is the relative risk aversion (RRA) and γπ,t = − JW = − b − 2cπt is the “inflation risk aversion”. According to the form of
value function (9), the relative risk aversion is constant. If JWπ > 0, i.e., γt, π < 0, then − b − 2cπ t < 0. Substituting b and c into the
4
inequality gives
∑
N
− ϕ(πt − μπ ) + (1 − γ) ωi σ i σ π σ iπ < 0, (15)
i=1
1− γ ∑
N
π t > μπ + ωi σ i σ π σ iπ . (16)
ϕ i=1
Fig. 1 plots the marginal value JW and the second-order cross-derivative of value with respect to wealth and inflation JWπ versus π.
∑
The marginal value of wealth JW is decreasing with π, if π is smaller than μπ + 1−ϕ γ i ωi σi σ π σiπ , which means that inflation increases in an
economy that suffered deflation are a positive signal for an agent to invest. On the contrary, positive shocks to inflation in a hyper
inflationary environment are bad news for an agent and thus increase the marginal value of wealth. Hence, an economy in deflation or
hyperinflation is associated with a high marginal utility and thus a high stochastic discount factor. The market aggregate asset price
evolves as
dSm,t ∑ N ∑N
= ωi μi dt + ωi σ i dzi . (17)
Sm,t i=1 i=1
Multiplying by dt both sides of Eq. (15) gives

( / )
Et (dπ t ) < (γ − 1)covt dSm,t Sm,t , dπt . (18)
Using a discrete-time approximation of the continuous-time equation and conditioning down to a coarser information set provide
( )
E(Δπt+1 ) < (γ − 1)cov Rm,t+1 , Δπ t+1 , (19)
where Rm is the market portfolio return and Δπt+1 = π t+1 − πt. In the periods between July 1995 and June 2015, the average increase is
− 0.14% per month, and the covariance between market return and increase in inflation is approximately 0. Inequality (19) holds in
this sample, i.e., increases in inflation are bad news for investors in China’s stock market.
The conditional covariance between asset i and the market’s instantaneous rate of return and that between the instantaneous rate of
return of asset i and a change in inflation are, respectively,
( )
dSi,t dSm,t
covt , = ωi σ 2i dt, (20)
Si,t Sm,t
( )
dSi,t
covt , dπ t = σ i σπ σ iπ dt. (21)
Si,t
Multiplying both sides of (14) by dt and substituting (20) and (21) into (14) lead to a two-factor ICAPM:
( ) ( ) ( )
D dSi,t dSm,t dSi,t
μi + i,t − r dt = γcovt , + γπ,t covt , dπt . (22)
Si,t Si,t Sm,t Si,t
The beta representation of the model is

( )
dSi,t Di,t
Et + dt − rdt = λm,t βi,m,t + λπ,t βi,π,t . (23)
Si,t Si,t
Similar to Cochrane (2005, Chapter 9), the approximate result in discrete time is
( ) ( ) ( )
Et Ri,t+1 − Rf ,t ≈ γcovt Ri,t+1 , Rm,t+1 + γπ,t covt Ri,t+1 , Δπt+1 , (24)
where Ri is the return of portfolio i, Rm is the market portfolio’s return, Rf is the risk-free rate, and Δπ is a shock in inflation. We will use
the discrete-time forms of covariance and beta representations to test whether the inflation can act as a state variable for investment
opportunities.
3. Data and econometric approach
3.1. Data source
The National Bureau of Statistics of China (NBSC) provides monthly data on year-on-year inflation yt = xt/xt− 12, where xt is the
( ) ( )
( )
consumer price index in month t. The logarithmic two-year inflation is πt ≡ log xt−xt24 = log xt−xt12 xxt−t− 1224
= log yt yt− 12 . We choose πt as
( )
the state variable in our ICAPM. Its monthly shock is Δπt = πt − π t− 1 = log xt−xt24 /xxt−t− 251 = log(xt /xt− 1 ) + log(xt− 24 /xt− 25 ), which is the
sum of the current monthly logarithmic inflation and that two years prior. Inflation measures with other horizons are calculated
5
Table 1
Summary statistics for Fama-French factors, state variable and its shock.
Mkt SMB HML RMW CMA π Δπ
Panel A: Statistics
Mean (%) 0.74 0.46 0.86 0.55 − 0.20 2.57 − 0.14
Stdev (%) 8.48 5.19 4.95 4.30 3.42 3.23 0.71
Skewness 0.28 − 0.67 1.06 0.35 − 0.10 2.26 − 0.37
Kurtosis 4.36 6.24 7.78 5.86 7.83 8.95 3.76
ρ 0.09 0.09 0.06 0.15 0.12 0.96 0.43
Panel B: Cross correlations

SMB 0.12
(1.81)
HML 0.12 − 0.24
(1.79) (− 3.86)
RMW − 0.08 − 0.47 − 0.27
(− 1.31) (− 8.21) (− 4.29)
CMA 0.03 0.31 0.40 − 0.71
(0.53) (5.00) (6.82) (− 15.67)
π 0.01 − 0.04 0.22 0.09 − 0.03
(0.11) (− 0.54) (3.41) (1.45) (− 0.53)
Δπ 0.02 − 0.04 − 0.14 − 0.01 − 0.06 − 0.33
(0.35) (− 0.58) (− 2.17) (− 0.15) (− 0.89) (− 5.46)
Panel A reports the statistics including mean, standard deviation (stdev), skewness, kurtosis, and first-order autocorrelation (ρ), for Fama-French
monthly percent factors, log two-year inflation π, and corresponding inflation shock Δπ. Panel B reports the correlation matrix. The t-statistics for
correlations are in the parentheses.
Fig. 2. Log two-year inflation (%) and total share price in Shanghai Stock Exchange.
according to the same method.

The portfolio returns and Fama-French factor data are from Guo et al. (2017). They use the China Stock Market & Accounting
Research (CSMAR) database to extract the accounting data and returns of listed Chinese firms. The stock sample covers all A-share
stocks listed on Shanghai and Shenzhen Main Boards, Shenzhen Small- and Medium-sized Enterprise Board (SMEB) and the Growth
Enterprise Market (GEM) except those with negative book value that are eliminated.
To enrich the dimensionality of the cross-section, we form 80 test portfolios that consist of 25 value-weighted (VW) portfolios
double sorted on size and book-to-market ratio (25 size-BM) and size and return on equity (25 size-ROE), and decile VW portfolios
single sorted on earnings-to-price ratio (10 EP), market leverage (10 AP), and research & development expenses to market (10 RD).
Because investment anomaly does not exist in Chinas stock market, we disregard portfolios sorted on investment. All portfolios we
choose produce significant return spreads at the 1% confidence level. The methods of forming portfolios are consistent with Fama and
French (1993, 2015): For 25 double sorted portfolios, at the end of June of year t, all available stocks are allocated independently to
five size groups using CSI 300 stock sample market cap quintiles. Similarly, stocks are allocated independently to five BM and ROE
groups respectively. The intersections of each two sorts produce 25 VW size-BM and size-ROE portfolios. Size is the market cap at this
time; BM is the book equity B at the end of year t-1 divided by the market cap M at the end of year t-1; ROE is earnings for year t-1
scaled by book equity at the end of year t-1. For deciles portfolios, at the end of June of year t, all available stocks are allocated
independently to ten EP, AP and RD groups using CSI 300 stock sample deciles, respectively. EP is the net income for year t-1 divided
by market cap at the end of year t-1; AP is total assets for year t-1 divided by market cap at the end of year t-1; RD is the selling, general
6
Table 2
Average monthly percent excess returns.
Panel A: 25 VW portfolios
size-BM size-ROE
Low 2 3 4 High Low 2 3 4 High
Small 0.70 1.19 1.44 1.70 1.64 1.03 1.36 1.50 1.64 1.33
2 0.57 1.06 1.52 1.10 1.51 0.47 1.15 0.91 1.33 1.28
3 0.29 0.41 0.85 1.68 1.18 0.58 0.23 1.01 1.09 1.63
4 0.57 0.19 1.49 0.79 1.25 0.24 0.56 0.72 0.96 0.92
Big 0.05 0.76 − 0.01 1.45 1.24 0.23 1.14 0.88 0.54 1.04
Panel B: Decile VW portfolios
Low 2 3 4 5 6 7 8 9 High
EP 0.29 0.60 0.75 1.01 0.94 0.76 0.96 1.23 1.42 1.37
AP 0.43 0.45 0.52 0.77 0.78 1.03 1.05 1.35 1.30 1.40
RD 0.63 0.68 0.81 0.72 1.08 1.10 0.74 0.88 1.06 1.22
Panel A reports the average excess returns for 25 VW size-BM and 25 VW size-ROE portfolios. Panel B reports the average excess returns for decile
portfolios single sorted by EP, AP and RD. All returns are deflated by consumer price index.
and administrative expenses for t-1 divided by market cap at the end of year t-1. The number of available stocks is 2592. We deflate all
returns and factors using monthly inflation xt/xt− 1. The changes in results due to deflating or not deflating returns are marginal. The
sample covers periods from July 1995 to June 2015 with the total duration of 240 months.
3.2. Summary statistics
Table 1 depicts summary statistics. In panel A, among the factors, the value factor of HML earns the greatest monthly risk premium
of 0.86% on average and thus has the largest Sharpe ratio of 0.17 = 0.86 / 4.93. In addition, the skewness of HML, the largest observed,
is greater than 1. As pointed out by Guo et al. (2017) and others, the investment factor CMA is redundant in China’s stock market.
Hence, its mean and skewness are negative in this sample. Because the smallest value of kurtosis among Fama-French factors is 4.36, all
factors clearly have fat-tailed distributions. In contrast to the highly persistent factors of the U.S. stock market, the largest first-order
autocorrelation is only 0.15.
Fig. 2 plots the time series of inflation πt and the total share price on the Shanghai Stock Exchange. The grey areas indicate
recessionary periods defined by the Organisation for Economic Co-operation and Development’s composite leading indicators (OECD-
CLIs).5 Inflation reflects business cycle patterns: πt typically declines in recessionary periods and increases in boom periods. Although
stock share prices are one of components of the OECD-CLIs, the patterns of share prices in recessionary periods are not consistent.
Between July 1995 and July 2000 and between January 2014 and June 2015, share prices rose; on the contrary, they declined during
the periods of December 2007–February 2009 and August 2001–November 2012. Hence, the prevalent view is that China’s stock prices
are unrelated to real macroeconomic activities. Table 1 shows that the mean and standard deviation of logarithmic two-year inflation π
expressed as a percentage are 2.57% and 3.24% per month, respectively, and that inflation has a fat-tailed distribution. Inflation π is
highly persistent with the first-order autocorrelation coefficient of 0.96. The mean and standard deviation of shocks in inflation are
− 0.14% and 0.71% per month, respectively, and the autocorrelation is lower at 0.43. The kurtosis of 3.76 indicates that the fat-tailed
feature is not apparent. Panel B shows that shocks in inflation have low correlation with return factors, where the largest absolute one
is − 0.14 with the t-statistic of − 2.17 for HML.
Table 2 presents the average monthly percentage returns in excess of the one-month risk-free rate. Panel A reports the average
excess returns for 25 VW portfolios. The return spreads between “Small-High” and “Big-Low” portfolios are 1.59% per month for size-
BM portfolios and 1.10% per month for size-ROE portfolios. Panel B shows the results for decile VW portfolios. The decile portfolios
sorted on EP earn the largest high-minus-low returns of 1.08% per month.
3.3. Econometric approach
Following Cochrane (2005, Chapter 12), we use the classical two-step regressions to estimate the asset pricing model at portfolio
level. Specifically, we run time series regressions for each portfolio i to obtain factor beta estimates in the first step:
(25)
′
Rei,t = ai + βi ft + εi,t , t = 1, 2, …, T,
5
The OECD-CLI system uses the value added to industry at prices as of 1995 as the reference for identification of recessions and booms of China’s
business cycles. The reference component series are industry production of chemical fertilizer, industry production of manufactured crude steel,
5000 Industrial Enterprises: Diffusion Index: Overseas Order Level, production of total construction, production of motor vehicles, and share prices:
Shanghai stock exchange turnover. Details are available at http://www.oecd.org/sdd/leading-indicators/
oecdcompositeleadingindicatorsreferenceturningpointsandcomponentseries.htm
7
where Rei, t = Ri, t − Rf, t is the excess return of portfolio i, ft is a vector of factors, and βi is a vector of betas for portfolio i with respect to
factors. In the second step, we run cross-sectional regressions of the average excess return on individual betas:
( )
(26)
′
ET Rei = βi λ + αi , i = 1, 2, …, N,
where ET(⋅) denotes the sample mean, λ is a vector of beta risk prices, and αi is the pricing error for portfolio i. The absence of the
intercept term reduces the freedom of the above regression and thus solves the multicollinearity problem of the intercept term and
betas for the market portfolio’s excess return, as noted by Jagannathan and Wang (2007). Numerous studies, such as Campbell and
Vuolteenaho (2004), Cochrane (2005, Chapter 12), Yogo (2006), Jagannathan and Wang (2007), Savov (2011), Maio and Santa-Clara
(2012, 2017), and Lioui and Maio (2014), use cross-sectional regressions without an intercept. As a supplement, we also test model
performance on conditional information. Using an instrument variable It that forecasts market return to construct managed portfolios
Rei, t+1It, we can condition down to an unconditional problem.
A good pricing model requires economically plausible and statistically significant risk prices λ and small individual pricing errors
αi = Reit − ̂ βîλ. Two metrics are used to measure the size of pricing errors: (1) mean absolute pricing error (MAPE, defined as
∑
i ∣ α
̂ i ∣ /N), and (2) cross-sectional adj.R2, measuring whether cross-sectional variations of pricing errors are small. We also provide a
χ 2 statistic testing whether pricing errors are jointly equal to zero (̂ α )− 1 ̂
α cov(̂ α ∼ χ 2 (N − K)), where K is the number of factors. We must
′
note that a model with a large MAPE can achieve a low χ 2 statistic by blowing up cov(̂ α ). Hence, we do not use χ 2 to measure the
6 2
performance of pricing models. We report the t-statistics for risk prices λ and χ by using the Lemma 4.1 of Hansen (1982). In addition,
we use the method of Newey and West (1987) to correct the t-statistic and χ 2.
Due to the shortage of portfolio-level regressions and tests discussed by Lewellen et al. (2010), we consider two-step regressions on
individual stocks. Following Fama and MacBeth (1973), numerous recent studies including Adrian et al. (2014), Chordia et al. (2015),
Boons (2016), Shen et al. (2017), Kim and Skoulakis (2018), etc. use rolling window time series regressions to estimate betas. However,
Cochrane (2005, Chapter 12.3) suggests a technique with full-sample betas that is available and simple. In the spirit of the GMM
procedure of Cochrane (2005, Chapter 12), we map the time series and cross-sectional regressions at stock-level into the GMM
framework. A disadvantage of rolling window betas is that the number of moments is very large, because this number for running time
series regression is equal to N × T. Considering the EIV problem in stock-level tests, Jagannathan et al. (2010) and Kim and Skoulakis
(2018) deduce an N-consistent estimator of risk prices
( ( ) − 1 / )− 1 ( )
̂
λ= ̂ β’̂
β − tr Σ̂ε Σ̂f T ̂
β’ET Rei , (27)
where Σε is the covariance matrix of time series’ residual ε and Σf is the covariance matrix of factors.7 The trace operator for a matrix is
denoted by tr(⋅). The moments are
⎡ ( e ) ⎤
E T R − a
̂ − ̂
βf t
⎢ [(
t
) ] ⎥
⎢ ⎥
( ) ⎢ ⎢ [ ET Ret − ̂ a− ̂ βft ft ⎥
⎥
( / ) ]
gT ̂b =⎢ ⎢
( ) −1 ⎥ = 0.
⎥ (28)
̂ e
⎢ ET β’Rt − ̂ ̂ ̂
β’ β − tr Σ ε Σ f ̂ T λ̂ ⎥
⎢ ⎥
⎣ ( ) ⎦
ET Ret − ̂β̂ λ
The top three moment conditions exactly identify a, β and λ; among these conditions, the first two identify a and β from time series
regressions, and the third condition identifies the N-consistent λ using (27). The last moment corresponds to pricing errors. Putting the
moments of pricing errors into gT gives the covariance matrix of pricing errors cov( α ̂ ), using the Lemma 4.1 of Hansen (1982). The
details of the GMM procedure are described in the appendix.
In addition, we also conduct a bootstrap simulation to test the sampling distribution of the described estimates and statistics. The
null hypothesis is that the pricing model is false. Hence, we simulate the portfolio returns and factors using independent time se
quences without imposing the ICAPM’s restrictions. We simulate 10,000 replications from the null and thus obtain the distributions of
t-statistics for beta risk prices λ, adj.R2 and χ 2. We provide 99% confidence intervals for these coefficients.
4. Cross-sectional regressions results
4.1. Portfolio-level regressions
In this section, we run portfolio-level cross-sectional regressions for CAPM, FF3F, FF5F and inflation-based two-factor ICAPM, and
6
See Cochrane (2005, Chapter 11).
7
Jagannathan et al. (2010) and Kim and Skoulakis (2018) describe an N-consistent estimator of risk prices based on a cross-sectional regression
with an intercept. Eq.(27) is a version of Theorem 7 of Jagannathan et al. (2010) without intercepts for compatibility with our cross-sectional
regressions.
8
Table 3
Cross-sectional regressions of portfolios.
CAPM FF3F FF5F Inflation ICAPM
Panel A: Risk prices

Mkt 0.92 0.86 0.78 0.81
(1.66) (1.56) (1.42) (1.45)
〈-1.96,1.97〉〈-2.24,2.22〉〈-2.38,2.30〉〈-2.08,2.06〉
[1.67] [1.57] [1.44] [1.44]
〈-2.25,2.52〉〈-2.71,2.69〉〈-2.82,2.75〉〈-2.77,2.66〉
SMB/Δπ 0.18 0.32 − 0.44
(0.51) (0.95) (¡2.90)
〈-1.72,1.73〉〈-2.21.2.14〉〈-2.10,2.03〉
[0.52] [1.00] [¡3.56]
〈-1.80,1.95〉〈-2.50,2.84〉〈-3.21,3.33〉
HML 0.50 0.73
(1.51) (2.25)
〈-2.18,2.27〉〈-2.30,2.35〉
[1.55] [2.35]
〈-2.29,3.07〉〈-2.43,2.86〉
RMW 0.57
(1.89)
〈-2.36,2.31〉
[2.11]
〈-2.51,2.88〉
CMA 0.06
(0.18)
〈-2.30,2.31〉
[0.29]
〈-2.76,2.56〉
Panel B: MAPE and cross-sectional statistics

MAPE 0.32 0.29 0.20 0.26
Adj.R2 0.11 0.21 0.62 0.38
〈-16.89,0.27〉〈-6.01,0.46〉〈-1.93,0.54〉〈-10.18,0.41〉
χ2 Shanken 214.84 201.79 150.05 154.43
(0.00) (0.00) (0.00) (0.00)
〈21.30,707.63〉〈25.67,615.03〉〈38.49,545.95〉〈22.19,644.90〉
2
χ NW 115.37 114.64 100.25 112.58
(0.00) (0.00) (0.00) (0.00)
〈4.77,225.92〉〈0.05,230.36〉〈0.02,227.64〉〈54.95,190.13〉
This table reports the cross-sectional regression results for different factor models. There is no cross-sectional intercept. The test portfolios are 25 VW
size-BM portfolio, 25 VW size-ROE portfolios, decile VW portfolios sorted on EP, AP and RD. CAPM is Capital Asset Pricing Model of Sharpe (1964)
and Lintner (1965); FF3F and FF5F are Fama and French (1993) three-factor model and Fama and French (2015) five-factor model respectively;
Inflation ICAPM is two-factor ICAPM with market excess return and shock in log two-year inflation. Panel A reports the estimates of the beta risk
prices λ, where Shanken (1992) t-statistics with i.i.d. time series regression errors are in parentheses and zero-lag Newey and West (1987) t-statistics
are in square brackets. Panel B reports mean absolute pricing error across all test portfolios (MAPE), adjusted cross-sectional adj. R2 and corre
sponding χ 2 statistics and p-values in parentheses. χ 2 tests whether the pricing errors are jointly equal to zero. The angle brackets reports the 99%
bootstrap confidence intervals for t-statistics, R2 and χ 2 from 10,000 pseudo-sample. The hypothesis of bootstrap simulation is that the pricing model
is not true. The bootstrap method is from Maio and Santa-Clara (2017).
test the performance of those factor models. To address the criticisms proposed by Lewellen et al. (2010), we incorporate 80 portfolios
mentioned in Section 3 to enrich the dimensionality of cross-section. Table 3 reports the results. Panel A shows the beta risk prices and
t-statistics adjusted by Shanken (1992) and Newey and West (1987) for each factor. Due to the high volatility of market return in
China, the risk prices of market excess return Mkt are positive, but not significant in all models. The risk prices of Mkt are less than 1.66
standard errors from zero. Similarly, the risk prices of size factor SMB are less than 1.00 standard error from zero, which is consistent
with Chen et al. (2010) and Guo et al. (2017). Due to the diversity of test portfolios, the risk price of value factor HML is less than 1.58
standard errors from zero in FF3F. On the contrary, the two types of value factor, HML and RMW, are more than 1.90 standard errors
from zero in FF5F. As pointed by Guo et al. (2017), because the investment factor CMA is redundant in China’s stock market, its risk
price is close to zero. Compared with risk prices of classical factors, the risk price of shock in inflation at − 0.44 is 2.90 standard errors
from zero under the adjustment of Shanken (1992) and 3.56 standard errors from zero under the adjustment of GMM, both of which are
significant at the 1% confidence level.
Panel B reports the MAPE, adj.R2 and χ 2 values adjusted by Shanken (1992) (χ 2Shanken) and Newey and West (1987) (χ 2NW). FF5F
achieves the smallest MAPE of 0.20% per month and the largest adj.R2 of 62% among the considered models. The inflation-based
ICAPM follows with an MAPE of 0.26% per month and adj.R2 of 38% and outperforms CAPM (MAPE of 0.32% per month and adj.
R2 of approximately 11%) and FF3F (MAPE of 0.29% per month and adj.R2 of approximately 21%). Fig. 3 plots the scatter diagrams of
the realized average excess returns versus predicted average excess returns. CAPM and FF3F cannot explain the diversity of excess
returns. For FF5F and inflation-based ICAPM, the assets line up close to the 45∘ line. The χ 2 statistics in all models reject the hypothesis
9
CAPM FF3F
2 2
S1B4
S3B4 S1B4
S3B4
RO04
S1B5
EP05 RO04
EP05 S1B5
1.5 RO03
S4B3S2B5S2B3 1.5 S4B3 S2B3
RO03 S2B5
Realized Excess Returns(%)

S5B4
S1B3 S5B4 S1B3
RD04 RD04
RD05
RO02 RD05
RO02
RO09RO05 RO09 RO05
RO10 RO10
S5B5
RD03S4B5 RD03 S5B5 S4B5
S1B2
S3B5 S1B2
RO07
AP02 AP02RO07S3B5
EP04S2B4 EP04S2B2 S2B4
S2B2
AP05 AP05 AP09
1 AP09RO01
EP03 1 EP03 RO01
EP09
RD02
AP10
EP10 EP09
EP10 AP10RD02
RO08
AP03 AP03RO08
S3B3 S3B3
S4B4RD10
RD09
S5B2
RD01 S5B2 S4B4
RD09RD10
RD01
AP08 AP08
EP08
S1B1 EP08
S1B1
AP07
S4B1
S2B1 S4B1 S2B1AP07
EP01
EP07 EP01
EP07
AP04
RD08 AP04
RD08
0.5 RD07RO06 0.5 RD07 RO06
RD06
S3B2 RD06 S3B2
S3B1AP06 S3B1 AP06
AP01EP06
EP02 EP02AP01
EP06
S4B2 S4B2
S5B1 S5B1
0 S5B3 0 S5B3
-0.2 -0.2
-0.2 0 0.5 1 1.5 2 -0.2 0 0.5 1 1.5 2
Predicted Excess Returns(%) Predicted Excess Returns(%)
FF5F Inflation-based ICAPM

2 2
S1B4
S3B4 S3B4 S1B4
RO04
EP05 S1B5 RO04
EP05 S1B5
1.5 S4B3 RO03 S2B3S2B5 1.5 S4B3 RO03 S2B3 S2B5


S1B3 S5B4 S1B3 S5B4
RD04 RD04
RO02 RD05 RO02 RD05
RO09 RO05 RO09 RO05
RO10 RO10
RD03 S5B5 S4B5 S5B5 S4B5
S1B2 S3B5 S1B2 RD03 S3B5 RO07
AP02 RO07 AP02
EP04S2B4 S2B4
S2B2 S2B2 EP04 AP05
1 AP09 RO01AP05
EP03 1 AP09 RO01
EP03
AP10
EP10 EP09
RD02 RD02
AP10
EP10 RO08 EP09
AP03 RO08 AP03
S3B3 S3B3
RD09RD10 S4B4
S5B2AP08 RD01 RD01 S5B2
AP08
S4B4
RD10
RD09
EP08
S1B1 EP08
S1B1
AP07 AP07
EP01S4B1 S2B1 EP07 S2B1 S4B1
EP01
EP07
AP04RD08 AP04 RD08
0.5 RD07 RO06 0.5 RD07 RO06
RD06 S3B2 RD06
S3B2
AP06
S3B1 S3B1 AP06
AP01 EP06 EP02 EP06
EP02 AP01
S4B2 S4B2
S5B1 S5B1
0 S5B3 0 S5B3
-0.2 -0.2
-0.2 0 0.5 1 1.5 2 -0.2 0 0.5 1 1.5 2
Fig. 3. Realized versus predicted excess returns. The figure shows the realized against predicted per month excess returns for 25 VW size-BM
portfolios, 25 VW size-ROE portfolios, decile portfolios sorted on EP, AP and RD. The estimated models are CAPM, Fama-French three- and five-
factor models, and Inflation-based ICAPM.
that the pricing errors are jointly equal to zero. Since cov(̂α ) is sensitive to the factors we choose, we do not use χ 2 to compare one
model with another. In the following regressions at stock-level, although the ICAPM earns the smallest MAPE among models, it
achieves the highest χ 2 statistics.
In panels A and B of Table 3, the angle brackets include 99% bootstrap confidence intervals for statistics obtained above using the
pseudosample of 10,000 replicate. The null hypothesis for bootstrap is that the model is false. A statistic located outside its bootstrap
confidence interval rejects the null; such statistics are shown in bold. In panel A, only the t-statistics of risk prices of inflation (− 2.93
and − 3.64) are outside the confidence interval. At the 5% bootstrap confidence level, the t-statistics of risk prices of two value factors,
HML and RMW, in FF5F are significant (not shown in the table). In panel B, only the cross-sectional adj.R2 of FF5F is significant at the
1% bootstrap confidence level. However, adj.R2 of inflation-based ICAPM (0.38) is close to the upper bound (0.41). In fact, the adj.R2
of 0.38 is significant at 5% bootstrap confidence level. Since χ 2 is highly sensitive to factors, its bootstrap confidence interval covers a
large scope. All χ 2 values are not significant at the 10% bootstrap confidence level.
4.2. Managed portfolios
We also test model performance in terms of conditioning information. For simplicity, we construct an instrument variable It that can
forecast the market portfolio’s excess return to formulate managed portfolios’ returns ItRi, t+q. We incorporate conditioning infor
mation by adding managed portfolios in unconditional moments.8 We run a predictive regression of continuously compounded market
returns from time t to t + q on π, one-month risk-free rate (rf), foreign currency reserves (FCRs), real estate sales (RESs) and an
intercept:
RM,t→t+q = a + b1 π t + b2 rf ,t + b3 FCRt + b4 RESt + εt+q . (29)
The instrument is represented by It = ̂

a +̂
b 1 π t +̂
b 2 rf,t +̂
b 3 FCRt +̂
b 4 RESt , where the parameters with caret symbols are estimated
8
See Cochrane (2005, Chapter 8).
10
Fig. 4. Forecasting market excess return. We run a regression of cumulative market excess returns RM, t→t+q on π, rf, FCR and RES at time t. The
horizonal axis denotes the months q. The left and right vertical axises denote the t-statistics and R2 respectively. The line represents the R2, and the
bars represent the t-statistics of estimates adjusted by Newey and West (1987) with lags q.
Table 4
Cross-sectional regressions with managed portfolios.
1 month lag 3 months lag 6 months lag
CAPM FF3F FF5F ICAPM CAPM FF3F FF5F ICAPM CAPM FF3F FF5F ICAPM

Mkt 0.92 0.85 0.77 0.80 0.93 0.87 0.80 0.81 1.05 1.00 0.91 0.92
(1.63) (1.53) (1.38) (1.43) (1.65) (1.56) (1.43) (1.44) (1.85) (1.77) (1.62) (1.63)
[1.64] [1.54] [1.41] [1.43] [1.66] [1.58] [1.46] [1.44] [1.86] [1.79] [1.61] [1.64]
SMB/Δπ 0.19 0.34 − 0.44 0.19 0.33 − 0.47 0.15 0.30 − 0.45
(0.55) (0.99) (¡2.86) (0.56) (0.96) (¡3.16) (0.44) (0.86) (¡3.09)
[0.56] [1.02] [¡3.52] [0.58] [1.00] [¡3.97] [0.45] [0.84] [¡3.98]
HML 0.49 0.73 0.39 0.63 0.42 0.63
(1.47) (2.20) (1.18) (1.94) (1.27) (1.94)
[1.51] [2.25] [1.23] [2.02] [1.31] [1.84]
RMW 0.58 0.61 0.63
(1.92) (2.03) (2.06)
[2.09] [2.24] [1.97]
CMA 0.09 − 0.07 0.03
(0.24) (− 0.27) (0.09)
[0.36] [− 0.27] [0.01]

MAPE 0.32 0.29 0.20 0.26 0.32 0.29 0.21 0.25 0.34 0.31 0.22 0.26
Adj.R2 0.11 0.22 0.64 0.38 0.12 0.19 0.61 0.43 0.17 0.23 0.63 0.46
This table reports the cross-sectional regressions for 80 original test portfolios and 80 managed portfolios, a total of 160 test portfolios. The instrument
variable It constructing the managed portfolios is the forecasting part of the right hand side of (29). We test the model performances using instrument
lagged 1, 3 and 6 months. The econometric and bootstrap methods are same with Table 3. The statistics that reject the null hypothesis of bootstrap
simulation that the model is not true at 1% confidence level are in bold.
using a sample. Fig. 4 plots the forecasting regressions’ results. R2 reaches a peak of 0.39 at q = 18 months. The four forecasting
variables help forecast returns at different horizons: e.g., RES is helpful in the short term; the risk-free rate, in the long term; and
inflation, in the medium term. The number of test portfolios increases to 160 and incorporates 80 additional managed portfolios.
Table 4 reports the results with instrument variable lags q of 1, 3, and 6 months. Since all models are rejected by the χ 2 test, we omit
χ 2 statistics. For saving spaces, we also omit the bootstrap confidence intervals. A statistic that reject the null of bootstsrap simulation
that the model is false at 1% confidence level are in bold. Adding managed portfolios does not clearly change the results in Table 3
regardless of the length of the instrument variable lag we choose. A good news for our ICAPM is that adj.R2 rejects the null of the
bootstrap simulation for 3- and 6-month lags of the instrument variable at the 1% confidence level.
Table 5 reports the results of one- to five-year inflation and average inflation across horizons. Except for the five-year inflation, all
11
Table 5
Inflations with other horizons.
Mkt π1y π3y π4y π5y πlevel π MAPE Adj.R2
Panel A: 80 original portfolios

0.83 − 0.31 0.29 0.22
(1.53) (− 2.00)
0.79 − 0.30 − 0.47 0.25 0.39
(1.42) (− 1.73) (− 3.67)
0.86 − 0.35 0.29 0.24
(1.55) (− 1.78)
0.80 − 0.35 − 0.45 0.26 0.39
(1.43) (− 1.75) (− 3.69)
0.92 − 0.01 0.32 0.10
(1.67) (− 0.04)
0.81 − 0.20 − 0.42 0.26 0.38
(1.45) (− 0.76) (− 3.18)
0.93 0.16 0.31 0.11
(1.68) (0.56)
0.81 − 0.07 − 0.40 0.25 0.39
(1.46) (− 0.24) (− 2.82)
0.92 − 0.07 0.32 0.10
(1.66) (− 0.34)
0.81 − 0.21 − 0.42 0.26 0.38
(1.45) (− 0.97) (− 3.02)
Panel B: 160 original portfolios

0.83 − 0.29 0.30 0.23
(1.52) (− 1.92)
0.78 − 0.30 − 0.46 0.26 0.40
(1.41) (− 1.76) (− 3.65)
0.87 − 0.37 0.30 0.26
(1.57) (− 1.88)
0.81 − 0.36 − 0.45 0.26 0.40
(1.44) (− 1.80) (− 3.62)
0.93 − 0.03 0.32 0.11
(1.67) (− 0.10)
0.81 − 0.20 − 0.42 0.26 0.39
(1.44) (− 0.76) (− 3.12)
0.92 0.16 0.32 0.12
(1.67) (0.54)
0.81 − 0.07 − 0.39 0.26 0.40
(1.44) (− 0.22) (− 2.75)
0.92 − 0.09 0.32 0.12
(1.66) (− 0.42)
0.81 − 0.21 − 0.42 0.26 0.39
(1.44) (− 0.95) (− 2.95)
This table reports the pricing powers of shocks in one-, three-, four- and five-year inflations, and average inflation across horizons πlevel. For each
candidate state variable, the two-year inflation is consider as a controlling variable. The test portfolios are 80 original test portfolios and 80 managed
portfolios using instrument lagged 1 month. The zero-lag Newey-West t-statistics are in parentheses.
shocks in inflation have negative risk prices. However, if two-year inflation is not considered, only the absolute t-statistic of one-year
inflation is greater than 2. Adding two-year inflation makes others not significant. The patterns of MAPE and adj.R2 indicate that the
two-year inflation subsumes inflation measures with other horizons at portfolio-level. This is the reason why we choose the two-year
inflation as a state variable.
4.3. Stock-level regressions
We use a GMM framework to incorporate the time-series and cross-sectional regressions, where the time series use the full sample
and the cross-sectional estimators are N-consistent as in Jagannathan et al. (2010). To test the covariance matrix of the pricing errors,
we add the pricing error moment conditions. We choose stocks with sample periods longer than 180 months, leaving 865 individual
stocks available. Alternative sample lengths do not change the main results.
Table 6 reports the results with and without EIV correction of Eq. (27).9 Panel A presents the beta risk prices and corresponding t-
statistics adjusted by GMM. Counter-intuitively, the beta risk prices of Mkt in CAPM is large and significant, which is different with the
traditional portfolio-level regressions in China. The beta risk prices of value factors HML and RMW decline and become negative and
insignificant. On the contrary, the beta risk price of inflation are more than 3.82 standard errors from zero, which is similar to the
( )
9
Without EIV correction, we estimate the beta risk prices λ from OLS cross-sectional regressions, i.e., ̂
λ = (̂ β)− 1 ̂
β’ ̂ β’ET Rei .
12
Table 6
Cross-sectional regressions of individual stocks using GMM.
CAPM FF3F FF5F Inflation ICAPM CAPM FF3F FF5F Inflation ICAPM
With EIV correction Without EIV correction

Mkt 2.17 1.58 1.24 1.51 2.16 1.59 1.28 1.53
(4.04) (2.33) (1.90) (2.66) (4.04) (2.41) (2.01) (2.73)
〈-2.84,3.34〉〈-3.07,3.18〉〈-2.91,2.55〉〈-3.23,3.22〉〈-2.97,3.52〉〈-3.13,3.44〉〈-3.41,2.75〉〈-3.21,3.43〉
SMB/Δπ 1.10 1.29 − 0.35 1.07 1.23 − 0.33
(1.42) (1.91) (¡3.92) (1.46) (1.91) (¡3.82)
〈-3.23,2.95〉〈-3.04,2.64〉〈-3.17,3.25〉〈-3.45,3.17〉〈-3.26,2.82〉〈-3.45,3.53〉
HML − 0.38 − 0.07 − 0.35 − 0.06
(− 0.55) (− 0.13) (− 0.53) (− 0.11)
〈-2.94,2.97〉〈-2.54,2.58〉〈-3.43,3.34〉〈-2.84,2.94〉
RMW − 0.28 − 0.25
(− 0.69) (− 0.63)
〈-2.83,2.27〉〈-3.35,2.49〉
CMA − 0.32 − 0.29
(− 0.64) (− 0.61)
〈-2.44,2.88〉〈-2.71,3.53〉

MAPE 0.92 0.94 0.90 0.74 0.92 0.93 0.88 0.73
Adj.R2 − 0.01 0.09 0.24 0.52 − 0.01 0.09 0.25 0.52
〈-0.57,0.31〉〈-0.69,0.23〉〈-1.06,0.28〉〈-0.61,0.30〉〈-0.44,0.31〉〈-0.47,0.30〉〈-0.46,0.37〉〈-0.48,0.32〉
χ2 338.82 315.54 343.89 505.50 328.00 306.67 333.82 395.88
(0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00)
This table reports the cross-sectional individual stocks regression results for different factor models. There is no cross-sectional intercept. The time
series betas are estimated using full sample. The moment conditions are
⎡ ( ) ⎤
ET Ret − ̂ a− ̂ βft
⎢ ⎥
( ) ⎢ E [( Re − ̂ a− ̂
) ]
βft ft ⎥
⎢ T t ⎥
gT ̂b =⎢ ⎥ = 0,
⎢ E [̂ e ̂ ̂ ̂ ⎥
⎣ T β’R − ( β’ β − Γ) λ ] ⎦
e
ET (R − ̂ β̂λ)
( ) −1
where Γ = tr Σ ̂ε Σ̂ /T with EIV correction raised by Jagannathan et al. (2010), and Γ = 0K×K without EIV correction. The top two row are time
f
series regressions moments, identifying ̂ a and ̂β, the third row are cross-sectional regressions moments, identifying N-consistent ̂ λ, the last row are
pricing errors moments. Panel A reports the N-consistent estimates of the beta risk prices λ and zero-lag Newey and West (1987) t-statistics in pa
rentheses. Panel B reports mean absolute pricing error across all stocks (MAPE, % per month), cross-sectional adj. R2 and corresponding χ 2 statistics
and p-values in parentheses. χ 2 tests whether the pricing errors are jointly equal to zero. We omit the stocks with available data less than 180 months.
The number of stocks is 865. The angle brackets reports the 99% bootstrap confidence intervals for t-statistics, R2 and χ 2 from 10,000 pseudo-sample.
The hypothesis of bootstrap simulation is that the pricing model is not true. The bootstrap method is from Maio and Santa-Clara (2017). The statistics
that reject the null hypothesis of bootstrap simulation that the model is not true at 1% confidence level are in bold.
results of portfolio level regressions. Because the stock number of 865 is not so much, the EIV correction does not fundamentally
change the results.
Panel B shows MAPE, adj.R2 and χ 2 statistics. The inflation-based ICAPM obtains the smallest MAPE and the largest adjR2 with and
without EIV correction. Fig. 5 shows the scatter plots of realized average excess returns versus predicted average excess returns. The
CAPM and Fama-French models cannot explain the diversity of excess returns. For inflation-based ICAPM, the assets are closer to the
45-degree line. As pointed out by Roll (1977), mispricings of individual stocks are averaged within portfolios, which causes a wrong
model to be likely to be accepted. All models are rejected by the χ 2 tests. It is notable that χ 2 and MAPE do not change in the same
direction. For example, with EIV correction, MAPE of 0.74 in our ICAPM is associated with the largest χ 2 of 505.50. Hence, χ 2 is
unsuitable as a measure of model performance.
In panels A and B of Table 6, the angle brackets include the 99% bootstrap confidence intervals for the above statistics. In panel A,
only the t-statistics of the risk prices of Mkt in CAPM and inflation in ICAPM are outside the confidence interval. In panel B, only the
cross-sectional adjR2 of ICAPM is significant at the 1% bootstrap confidence level. Since χ 2 is highly sensitive to the factors, the
bootstrap confidence interval is large. None of the χ 2 statistics are significant at the 10% bootstrap confidence level. For saving spaces,
we omit the bootstrap confidence intervals for χ 2 statistics. Hence, the bootstrap simulation supports the statement that the perfor
mance of the inflation-based ICAPM is not due to luck.
In summary, the inflation risk is statistically significant and economically plausible at stock- and portfolio-level. The negative beta
risk price implies that inflation increases are bad news in China. Because forming portfolio only characterizes risk in some particular
dimensions, inflation-based ICAPM does not outperform FF5F at portfolio-level.
13
CAPM FF3F
25 25

20 20
15 15
10 10
5 5
0 0
-5 -5
-5 0 5 10 15 20 25 -5 0 5 10 15 20 25
FF5F Inflation ICAPM

25 25

20 20
15 15
10 10
5 5
0 0
-5 -5
-5 0 5 10 15 20 25 -5 0 5 10 15 20 25
Fig. 5. Realized versus predicted excess returns at stock-level. The figure shows the realized against predicted per month excess returns for 865
individual stocks. The estimated models are CAPM, Fama-French three- and five-factor models, and Inflation-based ICAPM. The predicted excess
returns corrected by Eq. (20) are robust to EIV problem.
Table 7
Factor risk prices in cross-sectional regressions of mean returns on covariances.
CAPM FF3F FF5F Inflation ICAPM CAPM FF3F FF5F Inflation ICAPM
Panel A: 80 original portfolios Panel B: 160 portfolios
Mkt 1.88 1.13 − 0.14 1.68 2.28 1.57 0.38 1.42

(2.64) (1.51) (− 0.22) (2.60) (3.33) (2.17) (0.85) (3.19)
SMB/Δπ 1.43 5.80 − 61.45 1.10 5.29 − 85.00
(1.31) (5.01) (− 5.55) (1.04) (6.55) (− 14.83)
HML 3.19 7.44 2.66 6.11
(3.12) (6.03) (2.90) (7.00)
RMW 9.53 11.21
(4.97) (8.98)
CMA − 0.17 4.37
(− 0.06) (2.60)
This table reports the factor risk prices γ from the cross-sectional regression of mean returns on covariance of returns and factors, based on Eq. (19).
The estimation is by two-stage GMM. The test portfolios are 80 original and 80 managed portfolios using instrument lagged 1 month. Detail of
portfolios is in the online appendix. Panel A and B report the factor risk prices with 80 original portfolios and 160 total portfolios including 80
managed portfolios, respectively. The GMM t-statistics are in parentheses.
14
(caption on next page)
15
Fig. 6. Forecasting aggregate dividend growth with single state variable. The figure plots the estimate coefficients, t-statistics and adj.R2 of pre
dictive regressions of aggregate dividend growth on single state variable. The horizon is from 13 to 60 months. Each row represents a state variable.
The order from top to bottom is the state variable of SMB, HML, RMW and CMA, and two-year inflation. Two lines in each subfigure represent the
95% bootstrap confidence upper and lower bounds. A bar crossing the line implies that the null of no predictability of dividend growth is rejected at
corresponding horizon.
5. Consistency with ICAPM
Fama (1991) interprets ICAPM as a “fishing license” to multifactor model. However, Cochrane (2005, Chapter 9) emphasizes that
ICAPM is not such an expansive license and that there are some restrictions that state variables must satisfy. An asset that positively co-
varies with good news that forecasts aggregate wealth does not provide a hedge for an investment. Hence, the price of this asset should
be low, and its expected return should be high. In a multifactor model, there should be a positive risk price for the asset corresponding
to the factor representing good news.
Maio and Santa-Clara (2012) identify three restrictions. First, the RRA γ estimated from the cross-sectional regressions must be
statistically significant and economically plausible. Mehra and Prescott (1985) suggest that the RRA coefficient should be between one
and ten. Second, the ICAPM state variable must forecast the first and second moments of the aggregate market return. Third, the signs
of risk prices and corresponding forecasting slopes must be consistent. Specifically, a candidate state variable zt must have positive
slopes in forecasting regressions of market return and must have negative slopes in forecasting regressions of the variance of market
return if its shock has a significant positive risk price (λz or γz), and vice versa. In contrast to the above studies, Boons (2016) points out
that aggregate stock returns are not an ideal proxy for aggregate wealth returns due to employment, real estate and non-marketed
assets other than stocks and bonds. Hence, he uses several state variables to forecast macroeconomic activity, such as the Industrial
Production Index and Chicago Fed National Activity Index (CFNAI). A high future return may be due to a high future price rather than a
high cash flow received from the outside. Such a price bubble cannot raise the aggregate wealth of the economy. Hence, Koijen et al.
(2017) develop a multifactor model in which one of the state variables is the CP factor constructed by Cochrane and Piazzesi (2005).
That factor positively forecasts the CFNAI and the aggregate dividend growth, and its shock has a positive risk price.
In this section, we test whether CAPM, FF3F, FF5F and Inflation-based ICAPM hold the “fishing license”, using the aggregate
dividend growth and the variance of market returns as proxies of the stock market and the power generation capacity (PGC) and the
economic climate index (ECI) extracted from the NBSC as proxies of the macroeconomic activities in China. The ECI reflects the
business cycle in China, which is similar to the CFNAI in U.S. We deflate the aggregate dividend growth, PGC and ECI. However, using
nominal values leads to the same results.
5.1. Estimating RRA
Following Cochrane (2005, Chapter 13), we use a two-stage GMM procedure to estimate and test the cross-sectional regressions in
expected return-covariance representation (24). The moments are
⎡ [ ( ′ ) ] ⎤
′
( ) E T R e − R e f − μf b
gT b, μf = ⎣ ( ) ⎦, (30)
E T f − μf
where μf is a vector of mean factors or shocks in state variables. The first N moments are from cross-sectional regressions; the last K
moments are used to estimate the mean factors, and K is the number of factors. In the first-stage GMM, the moments’ weighting matrix
− 1
is W = IN+K, and in the second-stage GMM, W = ̂ S , where ̂ S is the estimated spectral density matrix of both sets of moments. There
are no lags in ̂
S, i.e., the pricing errors are orthogonal to all past information.
Due to lack of study considering EIV problem in expected return-covariance regressions, we use 80 portfolios and 80 corresponding
managed portfolios using instrument lagged 1 month in Section 4. Further expanding the test portfolios does not change the main
results. Table 7 reports the results. In panel A, the RRA of 1.88 is 2.64 standard errors from zero for CAPM, and the value of 1.68 is 2.60
standard errors from zero for inflation-based ICAPM. The RRA values in the Fama-French models are insignificant at the 10% level. It is
surprising that FF5F results in a negative RRA coefficient of − 0.14 even though this model previously obtained the largest cross-
sectional adj.R2 at portfolio-level. In panel B, all RRA values are between zero and three and are significant at the 1% level except
in the case of FF5F. In summary, the RRA coefficients estimated from the Fama-French models for China’s stock market are not
plausible, significant and robust.
The t-statistics of state variable risk aversion coefficients γz are typically larger than those of beta risk prices λz. The t-statistics of γ π
in the two panels are − 5.55 and − 14.83, respectively. In FF3F, the factor risk prices of HML are 3.19 and 2.66, respectively, and are
larger than 2.9 standard errors from zero. However, the factor risk prices of SMB are not significant. In FF5F, the t-statistics of γSMB,
γHML and γRMW are all above 4 regardless of whether we add managed portfolios. It is interesting that the t-statistic of factor risk price of
CMA increases to 2.08 if managed portfolios are considered, although CMA is a redundant factor for China’s stock market.
16
17
Fig. 7. Forecasting cumulative sum of SVAR. The figure plots the estimate coefficients, t-statistics and adj.R2 of predictive regressions of cumulative
sum of SVAR on single state variable. Each row represents a state variable. The order from top to bottom is the state variables for SMB, HML, RMW
and CMA, and two-year inflation. Two lines in each subfigure represent the 95% bootstrap confidence upper and lower bounds. A bar crossing the
line implies that the null of no predictability of SVAR is rejected at corresponding month.
5.2. Forecasting aggregate dividend growth and market return’s variance
We run predictive regressions of cumulative aggregate dividend growth Δd from time t to t + q on state variables at horizons q from
13 to 60 months ahead,
(31)
′
Δdt→t+q = aq + bq zt + εt+q .
We use the preceding 12 months of dividend data to construct the aggregate dividend growth; this approach is similar to that of
Koijen et al. (2017). Hence, there are no regression results at horizons q from 1 to 12. The candidate state variables are those for Fama-
French factors, zSMB, t, zHML, t, zRMW, t and zCMA, t, and two-year inflation πt. Since the Fama-French factors are shocks in the corre
sponding state variables, considering SMB as an example, we calculate its state variables zSMB, t by adding SMBt and zSMB, t− 1. The initial
value of the state variable is equal to SMB0. We consider single and multiple predictive regressions to test the sign of slope coefficients.
We also conduct a bootstrap simulation for predictive regressions to characterize the finite sample distribution of coefficient es
timates, t-statistics and adj.R2. The null hypothesis is that the aggregate dividend growth cannot be forecast by the candidate state
variables that evolve according to a VAR(1) process10:
Δdt→t+q = aq + εt+q , (32)
zt+1 = ϱ + ρzt + εt+1 . (33)

In each simulation, we bootstrap ε and ε using an identical time index, which preserves the time series relation between market
return and state variables. We use the simulated ε and ε to construct the artificial right- and left-hand side variables and subsequently
run a regression of the artificial market return on the artificial state variable(s) to obtain bq, t-statistic and adj.R2. We obtain the
distribution of coefficients by constructing 10,000 pseudosamples independently. A coefficient resulting from the original point
estimation that is outside its confidence interval rejects the null hypothesis of no predictability of market return. The simulation
procedure is similar to those of Cochrane (2008) and Maio and Santa-Clara (2012).
Fig. 6 shows the results of single regressions of future aggregate dividend growth, which includes slope estimates, t-statistics, adj.
R2, and 95% bootstrap confidence intervals for every variable. The standard errors are adjusted by Newey and West (1987) with lag q.
The signs of slopes of state variables for Fama-French factors are typically consistent with the signs of their risk prices. However, the
slopes of state variables for Fama-French factors are not significant: the t-statistics are smaller than 2 and are within the bootstrap
confidence intervals. Their slope estimates and adj.R2 perform better than their t-statistics, where the bootstrap intervals are crossed in
some horizons.
The three images in the last row correspond to two-year inflation. First, the signs of the slopes and risk prices are all negative.
Second, the absolute t-statistics are larger than 2 if horizon q is over 22 months. Third, values of adj.R2 are far greater than those of
regressions of state variables for Fama-French factors, where the largest one is close to 45% at 55-month horizon. Last but not the least,
these three variables are within 95% bootstrap confidence interval in most horizons, implying that two-year inflation indeed has the
forecasting power with respect to the aggregate dividend growth.
Next, we consider forecasting the volatility of market return. According to Guo (2006), Welch and Goyal (2008) and Maio and
Santa-Clara (2012), we compute the realized market return’s variance (SVAR) at month t as a sum of the squared daily market returns
during that month. We run single regressions of the cumulative sum of SVAR during months t to t + q on state variables zt,
(34)
′
SVARt→t+q = aq + bq ft + εt+q ,
where SVARt→t+q = SVARt+1 + … + SVARt+q. Fig. 7, similar to Fig. 6, plots the single regressions’ results. Since the risk prices of state
variables for Fama-French factors are positive, a negative slope coefficient is consistent with ICAPM. The slopes of zSMB are negative,
and all corresponding statistics reject the bootstrap null, which means that the state variable for SMB satisfies the variance restriction
of ICAPM. The insignificant slopes of HML and RMW vary around 0, and the bootstrap null hypotheses are not rejected, which means
that these two value factors are not consistent with ICAPM. Even though adj.R2 crosses the bootstrap confidence bound, the positive
and insignificant slope implies that the state variable for CMA is not consistent with ICAPM. The last row shows the results for two-year
inflation. Due to the negative risk prices of inflation, the inflation-based asset pricing model is consistent with ICAPM if the slopes are
positive. The slopes of two-year inflation are positive and are at least 2.5 standard errors from zero. More importantly, the bootstrap
null hypotheses are rejected. Hence, the two-year inflation satisfies the restriction of variance of market return.
10
The assumption that the state variables follow a VAR(12) process or processes with other lags does not affect the main results.
18
19
Fig. 8. Forecasting cumulative PGC growth. The figure plots the estimate coefficients, t-statistics and adj.R2 of predictive regressions of cumulative
PGC growth on single state variable. Each row represents a state variable. The order from top to bottom is the state variables for SMB, HML, RMW
and CMA, and two-year inflation. Two lines in each subfigure represent the 95% bootstrap confidence upper and lower bounds. A bar crossing the
line implies that the null of no predictability of SVAR is rejected at corresponding month.
5.3. Forecasting power generation capacity and economic climate index
Next, we forecast two macroeconomic activity variables: PGC and ECI. A significant slope with the same sign as that of risk prices
implies that the model is consistent with ICAPM. We run predictive regressions of cumulative PGC growth from t to t + q,
(35)
′
ΔPGCt→t+q = aq + bq zt + εt+q ,
where ΔPGCt→t+q = PGCt+q/PGCt. Fig. 8 plots the results for PGC growth. Although some of the slopes and adj.R2 reject the bootstrap
null hypothesis, the slopes of state variables for Fama-French factors are not significant, and the signs of state variables for HML and
RMW are not consistent with the signs of their risk prices. On the contrary, inflation satisfies the ICAPM restriction, as shown in the last
row of Fig. 6. The slopes are negative, which is consistent with the signs of the respective risk prices. The slopes are significant, where
the t-statistics are larger than 2. All statistics reject the bootstrap null in most horizons.
Similarly to the above, we run regressions of cumulative ECI on state variables,
(36)
′
ECI t→t+q = aq + bq zt + εt+q .
The ECI released by the NBSC is a gross percentage rate indicating the real activity growth. The cumulative ECI is the product of ECI
from t to t + q. Fig. 9 plots the ECI results. Among the state variables for Fama-French factors, zHML performs best: The slopes are
typically greater than 2 standard errors and are outside the confidence intervals; similarly, the adj.R2 values also reject the bootstrap
null. In the last row, negative and significant slopes are obtained for the two-year inflation, and the bootstrap null hypotheses are
typically rejected; i.e., the two-year inflation satisfies the macroeconomic environment’s restrictions.
5.4. Summary
Table 8 summarizes the consistency of multifactor models with ICAPM. Panel A reports the results for each state variable, and panel
B reports the results of each model. Only if all state variables in a model satisfy the restrictions is the model consistent with ICAPM.
Hence, the more state variables there are in a model, the more difficult it is for the model to be consistent with ICAPM. The inflation-
based model satisfies almost all restrictions except that the bootstrap null hypotheses are not rejected for a small part of the horizons.
6. Other macro-related candidate state variables
Along with the two-year inflation, we test the pricing power of inflation measures with other horizons. In addition to inflation, we
consider 6 other macro-related candidate state variables for ICAPM: consumption growth (CON), foreign currency reserve (FCR)
growth, M0 and M1 growth rates, change in fixed asset investment (FAI), and real estate sales (RESs). Data on all macroeconomic
variables are obtained from the CEInet statistics database.
6.1. Consumption growth
The leading studies of Rubinstein (1976), Breeden and Litzenberger (1978), Lucas (1978) and Breeden (1979) jointly introduce the
consumption-based CAPM using the consumption growth as the unique factor. However, a large body of literature notes the poor
performance of this model. Similar to Chen et al. (1986), we choose monthly consumption growth to match the frequency with that of
other data.
6.2. Foreign currency reserve growth
At the end of 2014, China’s foreign currency reserves amounted to 3840 billion dollars, representing the largest reserve worldwide.
Mendoza (2004), Caballero and Panageas (2008), Durdu et al. (2009), Obstfeld et al. (2010), Jeanne and Rancière (2011), etc. argue
that foreign currency reserves are maintained by emerging economies for precautionary reasons. However, it is commonly believed
that the exorbitantly large reserves impose unduly large costs on the economy. The relation between FCRs and asset returns remains
underexplored. We choose FCR as a candidate state variable to test its shock’s pricing ability.
6.3. M0 and M1 growth rates
Changes in monetary supply should affect asset prices, as argued by Svensson (1985), etc. Accordingly, we use changes in monetary
supply measured by M0 and M1 monthly growth as a candidate state variable.
20
21
Fig. 9. Forecasting cumulative ECI. The figure plots the estimate coefficients, t-statistics and adj.R2 of predictive regressions of cumulative ECI on
single state variable. Each row represents a state variable. The order from top to bottom is the state variables for SMB, HML, RMW and CMA, and
two-year inflation. Two lines in each subfigure represent the 95% bootstrap confidence upper and lower bounds. A bar crossing the line implies that
the null of no predictability of SVAR is rejected at corresponding month.
Table 8
A comparison of consistency of models.
γ γz, Δd γz, σ2(r) γz, ΔPGC γz, ECI Reject bootstrap null
Panel A: State variables

zSMB – Yes, not significant Yes Yes, not significant No –
zHML – Yes, not significant No No Yes –
zRMW – No No No Yes, not significant –
zCMA – Yes, not significant No Yes Yes, not significant –
π – Yes Yes Yes Yes –
Panel B: Models
CAPM Yes – – – – –
FF3F Not robust Yes, not significant No No No No
FF5F No No No No No No
Inflation-based ICAPM Yes Yes Yes Yes Yes Yes, most horizons
This table summarizes the consistency of state variables and models. γ indicates whether a statistically significant and economically plausible RRA is
estimated by corresponding model. γz, X indicates whether the signs of forecasting slopes of regressions of X are same with corresponding risk pri
ces.“Reject bootstrap null” indicates that whether the bootstrap null that the state variable cannot forecast investment opportunity proxies is rejected.
6.4. Fixed asset investment growth
Considering fixed asset investment, Qin and Song (2009) analyze the overinvestment situation in China and observe that over
investment remains even though the investment efficiency increases. According to the above study, we consider using FAI as a
candidate state variable.
6.5. Real estate sales growth
A growing body of literature is focused on the effects of real estate on asset prices (Cocco, 2005; Flavin and Yamashita, 2002; Flavin
and Nakagawa, 2008, among others). Piazzesi et al. (2007) develop a consumption-based equilibrium asset pricing model in which
housing is modeled as a consumption good. Following the above study, we use RES to represent the consumption growth of housing.
Similar to Table 6, Table 9 reports results of cross-sectional regressions at stock-level using EIV correction (27). We choose shocks in
two-year inflation as the controlling variable in even rows. The upper panel shows the results obtained using shocks in inflation
measures with other horizons and the average inflation across horizons. The shocks in midterm inflations (2–4 years) have significantly
negative beta risk prices and high adj.R2s, especially the three-year one that outperforms our benchmark model. Consider the relatively
weak performance of the shock in three-year inflation at portfolio-level in the online appendix, we still choose the two-year inflation as
a state variable. In sum, the strong pricing power of shocks in midterm inflations is pervasive, and not due to data mining.
The lower panel reports the results obtained using other macro-related candidate state variables. It proves the weak relationship
between macroeconomic conditions and the stock market in China. Except consumption growth, all variables are insignificant
regardless of whether the two-year inflation is considered. The two-year inflation subsumes the macro-related variables we have
chosen. It is surprising that, at stock-level, the beta risk price of consumption growth is significant, even after controlling Mkt and π,
which is totally different with the results at portfolio-level.
7. Conclusions
This paper provides evidence of the existence of inflation risk in China’s stock market, represented by two-year inflation. Inflation
increases that raise the marginal wealth value are bad news for investors. Shocks in inflation are contemporaneously negatively
correlated with real equity returns. A two-factor ICAPM including a state variable of inflation outperforms the Fama-French models at
portfolio- and stock-level. More importantly, considering the aggregate dividend growth, the variance in market return, PGC and ECI to
measure the investment opportunities’ set, we observe that the inflation-based asset pricing model is consistent with ICAPM.
It must be admitted that China’s stock market has a low correlation with several common macroeconomic variables, such as GDP
growth, consumption growth and other real activity variables. However, a growing number of studies show that China’s stock market
is gradually playing its financial role in allocating resources and hedging risks. Due to the particularities of China’s economic and
financial systems, the advisability of simply considering traditional macroeconomic variables in China is questionable. More studies
are needed to find a macro-related pricing model consistent with China’s national conditions.
22
Table 9
A set of macro-related candidate state variables.
Mkt π1y π3y π4y π5y πlevel π MAPE Adj.R2
1.99 − 0.11 0.86 0.03

(3.32) (− 0.53)
1.59 − 0.04 − 0.33 0.72 0.56
(2.86) (− 0.47) (− 4.44)
1.69 − 0.24 0.66 0.63
(3.24) (− 5.56)
1.57 − 0.25 − 0.19 0.65 0.66
(2.90) (− 5.17) (− 2.00)
1.78 − 0.32 0.79 0.31
(3.14) (− 2.90)
1.49 − 0.28 − 0.34 0.72 0.52
(2.61) (− 2.69) (− 3.59)
1.06 − 0.16 0.88 0.06
(3.78) (− 1.00)
1.47 − 0.19 − 0.36 0.76 0.56
(2.62) (− 1.69) (− 4.05)
1.79 − 0.24 0.79 0.31
(3.17) (− 3.05)
0.48 − 0.26 − 0.34 0.73 0.52
(2.58) (− 3.57) (− 3.70)
Mkt CON FCR M0 M1 FAI RES π MAPE Adj.R2
1.67 0.88 0.80 0.36
(3.26) (3.78)
1.44 0.61 − 0.31 0.70 0.57
(2.69) (2.57) (− 3.88)
1.14 0.54 0.92 0.09
(3.98) (0.77)
1.50 0.35 − 0.32 0.76 0.59
(2.74) (0.79) (− 3.34)
1.17 0.10 0.92 − 0.01
(4.16) (0.04)
1.49 − 1.26 − 0.32 0.74 0.56
(2.70) (− 0.75) (− 3.81)
1.16 0.58 0.87 0.06
(4.06) (0.68)
1.47 0.30 − 0.35 0.74 0.52
(2.59) (0.50) (− 3.91)
1.15 0.64 0.90 0.01
(3.97) (0.23)
1.50 1.04 − 0.35 0.74 0.54
(2.65) (0.55) (− 3.95)
1.13 2.71 0.90 0.00
(4.06) (0.46)
1.51 1.59 − 0.35 0.74 0.52
(2.68) (0.48) (− 3.81)
This table reports the beta risk prices of shocks in a set of macro-related candidate state variables with EIV correction (27). The left-hand-side
variables are returns of 865 individual stocks. The candidate state variables in upper panel are one-, three-, four- and five-year inflations, and
average inflation πlevel across horizons. The variables in lower panel are consumption growth (CON), foreign exchange reserve growth (FER), M0 and
M1 growths, fixed asset investment growth (FAI) and real estate sales growth (RES). For each state variable, the two-year inflation is consider as a
controlling variable. The zero-lag Newey-West t-statistics are in paretheses.
Author statement
I finish this paper independently, including conceptualization, data curation, formal analysis, funding acquisition, methodology,
software and writing. I certify that any part of this paper has not been published in any other publication before.
Declaration of Competing Interest
None.
Acknowledgements
We thank John Cochrane, Robert Faff, Bing Han, Xuezhong He, Khoa Hoang, Ravi Jagannathan, Junqing Kang, Shen Lin, Clark Liu,
Jiang Wang, Shouyu Yao, Xiaoquan Zhu, an anonymous referee, as well as seminar participants at the 2018 Chinese Finance Annual
Meeting in Guangzhou, FSERM 2019 in Tianjin, 2019 AsianFA annual meeting in Ho Chi Minh City, 2019 FMA asia/pacific conference
23
in Ho Chi Minh City, Jinan University, Tianjin University and Xiamen University for helpful comments and suggestions. Financial
support from the Fundamental Research Funds for the Central Universities (63212141) and the National Natural Science Foundation of
China (71790594, 71672087) is also gratefully acknowledged. Remaining errors are our own.
Appendix A. Appendix GMM procedure for cross-sectional regressions at stock-level
Cochrane (2005, Chapter 12.2) presents a GMM framework that incorporating the time-series and cross-sectional regressions. We
extend this method by introducing an N-consistent estimator of risk prices that is robust to the EIV problem.
We use the sample moment conditions as follow
⎡ ( e ) ⎤
E T R − a
̂ − ̂
βf t
⎢ [(
t
) ] ⎥
⎢ ⎥
( ) ⎢ ⎢ [ ET Ret − ̂ a− ̂ βft ft ⎥
̂ ⎢ ( ( ) / ) ] ⎥
⎥ = 0,
gT b = ⎢ − 1 ⎥
⎢ ET ̂
β’Ret − ̂
β’̂β − tr Σ ̂ε Σ ̂
f T ̂
λ ⎥
⎢ ⎥
⎣ ( e ) ⎦
ET R t − ̂β̂ λ
to estimate the coefficients ̂

b’ = [ ̂
a ’, ̂ λ’]. Since the number of moment (N(k + 1) + k + N) is larger than the number of coefficients (N
β’,̂
(k + 1) + k), the model is overall fit, where N is the number of stock and k is the number of factor. Hence, we estimate the coefficient by
( )
agT ̂b = 0, (1)
where a = [IN×(2k+1), 0(N(k+1)+K)×N]. The a matrix chooses the first, second and third rows of moment conditions to estimate. The last
row is used to obtain the distribution of pricing errors. By the Theorem 3.1 of Hansen (1982), the standard errors are
√̅̅̅̅( ) ( )
(2)
′
T ̂ b − b0 → N 0, (ad)− 1 aSa (ad)− 1’ ,
where b0 is the true values,

⎡ ⎡ ⎤ ⎤
[ ] E(f )
′
[ ]
⎢− 1 0N×k ⎥
− ⎣ E(f f ) ⎦ ⊗ IN
′
∂g(b) ⎢ ⊗ IN ⎥
E(f ) 0(N×k)×k
d≡ ′ =⎢⎢
⎥,
⎥ (3)
∂b ⎣ 0k×N A B ⎦
0N×N − ̂
λ ⊗ IN − ̂β
( ′ ( ) −1 )
( )′ ′ ′ ′ ′
A = Ik ⊗ ET Ret − [̂
β (̂λ ⊗ IN ) +Ik ⊗ ̂
λ̂ β ], and B = − β̂
̂ β − tr Σ λ). The S matrix is the long-run covariance matrix of
̂ /T ̂
̂ε Σ
f
sample moments
⎛ ⎡ ⎤’ ⎞
⎡ ⎤
⎜ Ret − ̂ a− ̂ βft ⎢ Ret− j − ̂ a− ̂ βft− j ⎥ ⎟
⎜⎢ ( e ) ⎥⎢ ( ) ⎥ ⎟
⎜⎢ R a ̂
βf ⎥⎢ e
Rt− j − ̂ ̂
a − βft− j ft− j ⎥ ⎟
∑ ⎜⎢
∞ ⎜⎢ t − ̂ − t ft ⎥⎢ ⎥ ⎟
( ( ) − 1/ ) ⎥⎢ ⎥ ⎟
S= ET ⎜⎢ ′ e ′ ⎥⎢ ′ ( ′ ( ) − 1/ ) ⎥ ⎟ (4)
⎜⎢ ̂
β R − ̂
β ̂
β − tr ̂ε Σ
Σ ̂ T ̂
λ ⎥⎢ ̂ e ̂
β̂ ̂ε Σ ̂ T ̂ ⎥ ⎟
j=− ∞ ⎜⎢ t f ⎥⎢ β Rt− j − β − tr Σ f λ ⎥ ⎟
⎜⎣ ⎦⎢ ⎥ ⎟
⎝ ⎣ ⎦ ⎠
Ret − ̂ β̂
λ Ret− j − ̂
β̂λ
The Lemma 4.1 of Hansen (1982) gives the sampling distribution of the moments
√̅̅̅̅ ( ) [ ( ) ( )′ ]
b → N 0, I − d(ad)− 1 a S I − d(ad)− 1 a
T gT ̂ (5)
The N-by-N matrix on the lower right corner of the covariance matrix of all moments is the covariance matrix of the pricing errors
α ). Hence, we could test whether all pricing errors are jointly equal to zero by using the χ 2 statistic
cov(̂
(6)
′
α
̂ cov( α ̂ ∼ χ 2N− k ,
̂)α
(
)
where αi = ET Reit − ̂
βî
λ.
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Pacific-Basin Finance Journal

An inflation-based ICAPM in China

E-mail address: hanzhang@nankai.edu.cn.

We guess that the value function takes the form

Gathering terms of π2 gives

Gathering terms of π gives

which implies that

Gathering constant term implies that

The first-order condition of (8) with respect to asset weight gives

Multiplying by dt both sides of Eq. (15) gives

The beta representation of the model is

3. Data and econometric approach

3.1. Data source

Panel B: Cross correlations

according to the same method.

Low 2 3 4 High Low 2 3 4 High

Panel B: Decile VW portfolios

3.2. Summary statistics

3.3. Econometric approach

4. Cross-sectional regressions results

4.1. Portfolio-level regressions

Panel A: Risk prices

Panel B: MAPE and cross-sectional statistics

Realized Excess Returns(%)

FF5F Inflation-based ICAPM

1.5 S4B3 RO03 S2B3S2B5 1.5 S4B3 RO03 S2B3 S2B5

Realized Excess Returns(%)

4.2. Managed portfolios

The instrument is represented by It = ̂

Panel A: Risk prices

Panel B: MAPE and cross-sectional statistics

Panel A: 80 original portfolios

Panel B: 160 original portfolios

4.3. Stock-level regressions

With EIV correction Without EIV correction

Panel A: Risk prices

Panel B: MAPE and cross-sectional statistics

Realized Excess Returns(%)

FF5F Inflation ICAPM

Realized Excess Returns(%)

Panel A: 80 original portfolios Panel B: 160 portfolios

Mkt 1.88 1.13 − 0.14 1.68 2.28 1.57 0.38 1.42

(caption on next page)

5. Consistency with ICAPM

5.1. Estimating RRA

(caption on next page)

5.2. Forecasting aggregate dividend growth and market return’s variance

zt+1 = ϱ + ρzt + εt+1 . (33)

(caption on next page)

5.3. Forecasting power generation capacity and economic climate index

6. Other macro-related candidate state variables

6.1. Consumption growth

6.2. Foreign currency reserve growth

6.3. M0 and M1 growth rates

(caption on next page)

Panel A: State variables

6.4. Fixed asset investment growth

6.5. Real estate sales growth

1.99 − 0.11 0.86 0.03

Declaration of Competing Interest

Appendix A. Appendix GMM procedure for cross-sectional regressions at stock-level