Working Paper: NBER ID: w30241
Authors: Leonid Kogan; Jun Li; Harold Zhang
Abstract: We show theoretically that variable production costs lower systematic risk of firms’ cash flows if capital and variable inputs are complementary in firms’ production and input prices are pro-cyclical. In our dynamic model, this operating hedge effect is weaker for more profitable firms, giving rise to a gross profitability premium. Moreover, gross profitability and value factors are distinct and negatively correlated, and their premia are not captured by the CAPM. We estimate the model by the simulated method of moments, and find that its main implications for stock returns and cash flow dynamics are quantitatively consistent with the data.
Keywords: operating hedge; gross profitability premium; systematic risk; cash flows; stock returns
JEL Codes: E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Variable production costs (D24) | Systematic risk of firms' cash flows (G32) |
| Capital and variable inputs are complementary (D24) | Variable production costs lower systematic risk of firms' cash flows (D25) |
| Input prices are procyclical (E30) | Variable production costs lower systematic risk of firms' cash flows (D25) |
| Negative aggregate profitability shocks (D81) | Firms reduce variable inputs (D21) |
| Firms reduce variable inputs (D21) | Decline in variable costs compared to revenue (D22) |
| Higher gross profitability (L21) | Lower ratios of variable costs to revenue (G32) |
| Lower ratios of variable costs to revenue (G32) | Weaker operating hedge (G19) |
| Weaker operating hedge (G19) | Higher systematic risk (G32) |
| Gross profitability and value factors are distinct (D46) | Emergence of gross profitability premium (G19) |