Working Paper: CEPR ID: DP3482
Authors: Joao Gomes; Leonid Kogan; Lu Zhang
Abstract: We explicitly link expected stock returns to firm characteristics such as firm size and book-to-market ratio in a dynamic general equilibrium production economy. Despite the fact that stock returns in the model are characterized by an intertemporal CAPM with the market portfolio as the only factor, size and book-to-market play separate roles in describing the cross-section of returns. These firm characteristics appear to predict stock returns because they are correlated with the true conditional market ß of returns. These cross-sectional relations can subsist after one controls for a typical empirical estimate of market ß This lends support to the view that the documented ability of size and book-to-market to explain the cross-section of stock returns is not necessarily inconsistent with a single-factor conditional CAPM model
Keywords: beta; size; book-to-market factors; business cycle; properties of stock returns; CAPM; production-based asset pricing
JEL Codes: E22; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| firm characteristics (size, book-to-market ratio) (L25) | expected stock returns (G17) |
| expected stock returns (G17) | true conditional market returns (G17) |
| cross-sectional dispersion in individual stock returns (C46) | aggregate stock market volatility (G17) |
| cross-sectional dispersion in individual stock returns (C46) | business cycle conditions (E32) |
| size and book-to-market return premia (G12) | conditional market returns (G19) |