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Definition: Intertemporal Capital Asset Pricing Model (ICAPM)
The Intertemporal Capital Asset Pricing Model (ICAPM) is a consumption-based asset pricing model that provides the expected return on a security. ICAPM first introduced by Merton in 1973, is an extension of CAPM that additionally accounts for time-varying factors. ICAPM assumes that investors will try to hedge their risky positions based on current and projected factors such as inflation, future returns, unemployment rate, etc.
The ICAPM portfolio thus includes the primary investment linked to the market as well as one or more hedging portfolios to mitigate the perceived risk. Since each investor has a different risk appetite, the correct factor to be used to weigh the hedging portfolios will vary across investors. ICAPM uses a mean-variance analysis to arrive at a normal distribution for the consumption risk over time. It covers multiple time-periods and incorporates multiple beta coefficients to account for the different hedging portfolios. The expected return for an investor can be calculated using ICAPM accounting for various global factors as:
Ri = Rf + β*(Rm - Rf) + βj*(Rn – Rf)
Ri is the expected return on stock i; Rf is the risk free rate; Rm is the return on the market portfolio and Rn is the expected return on the hedging portfolio that is used to mitigate the perceived risk from the core investment security i.
Β represents the measure of systematic risk with respect to the market portfolio and βj represents the measure of volatility with respect to the hedging security.
ICAPM assumes that the international capital market is integrated. If the market is segmented, discrepancies in asset prices with similar risk profiles arise as a result of the different currencies used to account for it. This leads to inefficient asset pricing. ICAPM can be used to select optimal portfolios by having an understanding of the impact of currency movements on asset pricing for assets with similar risk profiles but in different countries.