The Demographics of Innovation and Asset Returns
Posted: 17 Aug 2008
Date Written: August 15, 2008
We propose a study of an important source of stock market risk, the displacement risk. We focus on the fundamental inequality among firms and consumers with respect to technological innovation. New firms are the primary innovators who increase the overall productivity, but also steal business from older firms. Likewise, skills of younger households are better aligned with new technologies, while the human capital of older agents does not quite keep up with technological progress. Innovation activity increases total output while reducing the share of existing firms' profits in aggregate output. This displacement risk makes households reluctant to own stocks, particularly those of value firms, whose output is relatively exposed to the risk of increased innovation and competition by new firms, while assigning hedging value to growth firms, which profit from innovation. We propose a quantitative general-equilibrium model of displacement risk and offer an intuitive fundamental explanation of several basic empirical asset-pricing facts, including the high value premium, the high equity premium, and the low and stable risk-free rate. Our preliminary calibration results suggest that our model performs well quantitatively. Moreover, our model has unique empirical implications connecting historical returns on value and growth stocks to cross-sectional differences in consumption among households. Preliminary empirical analysis supports these implications of our theory.
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