The Value Premium in a Large-Cross Section of Test Portfolios

Abstract:     
We develop a new asset pricing testing methodology that greatly expands the set of test portfolios. By eliminating the strong factor structure of the 25 Fama-French portfolios used in previous tests, our approach improves the evaluation and comparison of asset pricing models. Armed with this methodology, we examine whether the human capital CAPM and the conditional CAPM capture the "leverage" or "distress" risk associated with high book-to-market firms. The empirical evidence shows that portfolios with high operating and financial leverage tend to have: (i) a positive exposure to human capital risk, and (ii) a market beta that rises in recessions, when the market risk premium is high. Consistent with these findings, these two models are able to partly -- but not fully -- explain the value premium. Overall, this paper helps reconcile the conflicting results obtained in past studies by highlighting the relative merits, as well as the failures of each model.

Number of Pages in PDF File: 50

working papers series