The Size Premium: What Role Does Macroeconomic Risk Play?

Abstract

The size effect is alive well but visible only when the economy is in a high volatility regime. This result is robust across different sample periods and model specifications. Independent business cycle and volatility regimes are identified from bivariate regime switching models of the industrial production growth and the small firm premium (SMB). The SMB factor is not priced by the market excess return (RMRF) and the value premium (HML) in the high volatility regime rather than in a recession regime. This new result is not explained by the January effect. An economic story for the size premium is provided through the capital market imperfection hypothesis.

Keywords: The Size Premium, Volatility Regime Switching, Capital Market Imperfections

JEL Classification: E32, E52, G12