Firm Characteristics, Consumption Risk, and Firm-Level Risk Exposures
46 Pages Posted: 2 Nov 2014 Last revised: 30 Nov 2015
Date Written: October 31, 2014
Firm-level risk exposures and costs of equity are notoriously difficult to estimate. Using a novel approach mapping consumption risk exposures to firm characteristics, we combine the traditional portfolio-level approach to testing asset pricing models with firm-level information to measure firm-level risk exposures. First, at the portfolio level, we investigate the empirical performance of a simple two-factor consumption-based asset pricing model for the cross-section of equity returns. The priced factors in the model are innovations in the growth and volatility of aggregate consumption. Our empirical results show that this model can explain 66% of the cross-sectional variation in returns on a menu of 55 portfolios spanning size, value, momentum, asset growth, stock issuance, and accruals. Second, we use the estimated model to map point-in-time firm characteristics to consumption risk exposures. Through this measurement procedure, we uncover sizeable cross-sectional and time-series variation in firm consumption risk exposures. We verify that sorting on these ex ante consumption risk exposures produces portfolios with consistent ex post risk exposures and predicts cross-sectional variation in future firm equity returns.
Keywords: Asset Pricing, Consumption-Based Asset Pricing, Cross-Section of Returns
JEL Classification: G12, E44
Suggested Citation: Suggested Citation