An Empirical Assessment of Models of the Value Premium

55 Pages Posted: 19 Jun 2011 Last revised: 8 Apr 2014

Huijun Wang

University of Delaware

Jianfeng Yu

University of Minnesota

Date Written: January 2014

Abstract

Recent models of the value premium typically endogenously link B/M to firm-specific attributes. The value firms earn higher subsequent returns because these firms command a higher risk premium due to a higher default probability, lower profitability, higher operating leverage, shorter cash flow duration, or higher cash flow risk. In this paper, we first sort the entire sample into several groups of firms based on different levels of limits to arbitrage, across which the value premium varies substantially. We find that among the low limits-to-arbitrage groups in which the value premium is relatively small, there is indeed a significant desired relation between B/M and firm-specific attributes. In sharp contrast, among the high limits-to-arbitrage groups in which the value premium is the most pronounced, there is no significant desired relation between B/M and firm-specific attributes. These results are robust to exclusion of small stocks. Our findings suggest that risk may play a role in the value premium only among the low limits-to-arbitrage group, whereas mispricing plays a significant role among the high limits-to-arbitrage group.

Keywords: value premium, mispricing, limits to arbitrage, financial distress, default risk, profitability, duration, cash flow risk, operating leverage

JEL Classification: G12

Suggested Citation

Wang, Huijun and Yu, Jianfeng, An Empirical Assessment of Models of the Value Premium (January 2014). AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1866397 or http://dx.doi.org/10.2139/ssrn.1866397

Huijun Wang

University of Delaware ( email )

B & E Finance, UD
306 Purnell Hall
NEWARK, DE Delaware 19716
United States

Jianfeng Yu (Contact Author)

University of Minnesota ( email )

321 19th Avenue
Suite 3-122
Minneapolis, MN 55455
United States

HOME PAGE: http://users.cla.umn.edu/~jianfeng/

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