The Cross-Section of Expected Stock Returns: Learning about Distress and Predictability in Heterogeneous Orchards

Abstract:     
We study an equilibrium asset pricing model with several Lucas (1978) trees subject to persistent distress events, where the agent has incomplete information about the state of an underlying common factor and learns from the events occurring to each tree. Contrary to similar asset pricing models with learning in one-tree economies, we find that cross-sectional learning and distress events can reverse several implications and help to explain empirical equity premia and risk-free rate dynamics. We also find that learning helps to generate more realistic dispersion of cross-sectional expected returns, relative to pure aggregate consumption risk models with complete information and disaster risk. The model provides a simple setting to study the asset pricing implications of orchards in which the cash flow links among different trees are asymmetric and some trees are more exogeneous than others. This allows, among other things, to link reduced-form assumptions of cash-flow risk heterogeneity to the structural properties of the orchard. Finally, we show that the cash-flow connectivity of a firm in the orchard is linked to the slope of the dividend strip curve. Sectors whose dividend process is exogenous in the orchard have negatively sloped term structures of dividend swaps. The opposite holds for endogenous sectors.

Number of Pages in PDF File: 84

Keywords: General Equilibrium, Event Risk, Learning

JEL Classification: G12, G13, D50

working papers series