Trading Volume: Implications of An Intertemporal Capital Asset Pricing Model

We derive an intertemporal capital asset pricing model with multiple assets and heterogeneous investors, and explore its implications for the behavior of trading volume and asset returns. Assets contain two types of risks: market risk and the risk of changing market conditions. We show that investors trade only in two portfolios: the market portfolio, and a hedging portfolio, which allows them to hedge the dynamic risk. This implies that trading volume of individual assets exhibit a two-factor structure, and their factor loadings depend on their weights in the hedging portfolio. This allows us to empirically identify the hedging portfolio using volume data. We then test the two properties of the hedging portfolio: its return provides the best predictor of future market returns and its return together with the return of the market portfolio are the two risk factors determining the cross-section of asset returns. We thank Joon Chae, Ilan Guedj, Jannette Papastaikoudi, Antti Petajisto, and Jean-Paul Sursock for excellent research assistance, and Jonathan Lewellen for providing his industry classification scheme. We are grateful to seminar and conference participants at the Chinese University of Hong Kong, Georgetown University, the Shenzhen Stock Exchange, UCLA, University of Pennsylvania, the 8th World Congress of the Econometric Society, and the 2001 Lectures in Financial Economics in Beijing and Taipei for helpful comments and suggestions. Financial support from the MIT Laboratory for Financial Engineering and the National Science Foundation (Grant No. SBR–9709976) is gratefully acknowledged. MIT Sloan School of Management, Cambridge, MA 02142-1347 and NBER.