Investment and Returns
London Business School
AFA 2006 Boston Meetings Paper
This paper constructs a general equilibrium production economy with heterogeneous firms and irreversible investment that rationalizes the value premium. Firm investments play a central role in explaining the cross-sectional variation of stock returns. Profitable and fast growing growth firms have low expected returns because they provide consumption insurance to investors, especially in bad times. Countercyclical consumption volatility generates a larger value premium during recessions. Large firms grow more slowly, so the value premium is larger for small stocks. The model can replicate the failure of the unconditional CAPM and the relative success of the conditional CAPM and Fama and French (1993) factor model.
Keywords: Asset Pricing, Production, Investment, General Equilibrium
JEL Classification: G12, D91, D92, D51, C68, D21, D24working papers series
Date posted: March 24, 2005
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