Common Stocks as Hedges Against Shifts in the Consumption or Investment Opportunity Set

The purpose of this paper is to explore the potential of using common stocks as hedges against unanticipated shifts over time in investors' consumption or investment opportunity sets. The generalized or multiperiod capital asset pricing model (CAPM) developed in different forms by Merton (1973), Long (1974), Richard (1977), and Breeden (1979) forms the basis for this exploration. In this model, shifts in investors' consumption or investment opportunity sets are caused by changes in the stochastic elements of the state of the world that affect investor taste for wealth. The state of the world is defined in terms of the level of state variables so that unanticipated changes in the levels of the state variables imply or are associated with changes in the state of the world. The analysis of this paper does not constitute a test of the generalized CAPM, because hedging potential is a necessary but not sufficient condition for the generalized CAPM to improve upon the traditional two-factor model. The existence of hedging potential is of interest in itself, howThis paper contains an investigation of the potential for using NYSE stocks as hedges against changes in the consumptioninvestment opportunity set. We perform this investigation under two characterizations of a multiperiod or generalized capital asset pricing model. We find sufficient crosssectional dispersion in common stock return covariances with unanticipated changes in real GNP, the price level, and aggregate consumption that hedge portfolios offer meaningful hedging potential in the portfolioformation period. The positive hedging potential persists out of the portfolio-formation period, but is strongly significant only for consumption.