Abstract
Campbell, Polk and Vuolteenaho (2010) determine the source of systematic risks in asset prices by assuming that the cash flow news is driven by fundamentals whereas discount rate news is sentiment driven. This study empirically evaluates their assumptions by constructing a four-beta model that disentangles the cash flow and discount rate betas of Campbell and Vuolteenaho (2004) into rational and irrational components. The empirical results do not support their assumptions in that the stock returns respond significantly to the shocks in the irrationally expected cash flow and rational discount rate. Comparing the asset pricing performance of our four-beta model against alternative asset pricing models reveals that our model has a better model fit with lower pricing error. The documented negative (positive) risk premia of irrational (rational) betas implies that investors are willing to pay a price (require a risk premium) for stocks that are sensitive to the irrational risk factors (rational risk factors).