We develop a new approach for testing conditional asset pricing models
that avoids the issues in using realized returns as a proxy for expected
returns. Testable restrictions are developed by asking what realized
returns we would observe, given the pricing model under scrutiny. The
new reverse testing approach is used to test the Merton ICAPM and a
long-standing risk–return puzzle: the price of market risk has often
turned out to be insignificant and at times even negative. The results
from the new testing approach on US data give strong support for a
positive relationship between conditional variance and the equity
premium.