Working Paper: NBER ID: w3452
Authors: William C. Brainard; Matthew D. Shapiro; John B. Shoven
Abstract: Much of James Tobin's professional life has been devoted to studying the interrelationship between the goods and financial markets. His general equilibrium approaches stresses the interaction of the demand for financial assets with the decision to accumulate productive capital. His emphasis on q, the ratio of market value of assets to their replacement cost, has shaped how students of the aggregate economy understand the link between the stock market and fixed investment. This paper examines the empirical linkage between fundamental returns on physical corporate assets and market return on financial claims on those assets. It defines the fundamental return as real cash flow divided by replacement cost. It examines whether the market return on individual firms respond more to aggregate shocks to the fundamental return or to the market return itself. It then examines whether aggregate market risk or aggregate fundamental risk is priced. Although market risk is priced, the paper does find that fundamental risk is an important factor in explaining risk premia.
Keywords: fundamental returns; market returns; risk premium; investment
JEL Codes: G12; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fundamental returns (G12) | Market returns (G19) |
| Aggregate shocks (E19) | Individual firms' market returns (L19) |
| Market risk (G19) | Risk premia (G19) |
| Fundamental risk (G32) | Risk premia (G19) |