The Value Premium

Abstract

I investigate the economic determinants of risk and expected return within a neoclassic framework of industry equilibrium augmented with capital investment and aggregate uncertainty. Due to asymmetry in capital adjustment cost, assets-in-place is much riskier than growth option in bad times and growth option is riskier than assets-in-place only in good times and to a lesser extent. Coupled with a time-varying price of risk, this mechanism goes a long way in explaining the value premium puzzle, the coexistence of a high return dispersion and a low unconditional beta dispersion between value and growth stocks. The model also yields an array of new testable predictions both in the time series and cross-section.

Keywords: The Value Premium, Industry Equilibrium, Optimal Investment, Assets-in-Place, Growth Option, Asymmetric Adjustment Cost

JEL Classification: G1