Can Idiosyncratic Cash Flow Shocks Explain Asset Pricing Anomalies?

Abstract:     
Asset pricing anomalies appear in a model where systematic and idiosyncratic demand shocks have non-multiplicative effects on firm value. Specifically, we show that firms' conditional betas directly depend on the past realizations of firm-specific shocks, giving rise to a value premium. A separate size effect arises because firms that experience positive idiosyncratic shocks increase in size and exercise their options, thereby decreasing their betas. Further, because stocks with more unique assets tend to have higher idiosyncratic volatility and lower betas, our results can explain the observed negative relation between idiosyncratic volatility and stock returns. More generally, our results imply that any economic variable correlated with the history of firm-specific cash flow shocks can be successful in explaining expected stock returns.

Number of Pages in PDF File: 49

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