Asset Pricing with Misallocation

72 Pages Posted: 10 Apr 2020 Last revised: 2 Jul 2021

See all articles by Winston Dou

Winston Dou

The Wharton School, University of Pennsylvania

Yan Ji

Hong Kong University of Science & Technology (HKUST)

Di Tian

Department of Economics at University of Pennsylvania

Pengfei Wang

Peking University HSBC Business School

Date Written: July 2, 2021

Abstract

Misallocation reduces total factor productivity and economic growth, implying substantial adverse welfare effects. Misallocation measures should therefore provide a more informative empirical stochastic discount factor than aggregate consumption time series in small samples. We find evidence for misallocation-driven low-frequency movements in both aggregate growth and stock returns. We then develop an endogenous growth model with heterogeneous firms, intermediate goods, and financial frictions, in which misallocation emerges analytically as a crucial state variable. In equilibrium, misallocation endogenously generates long-run uncertainty about economic growth by distorting innovation and R&D decisions, leading to significant welfare losses and risk premia in capital markets. Empirically, a two-factor model with market and misallocation factors prices size, book-to-market, momentum, and bond portfolios with an R-squared and a mean absolute pricing error close to the Fama-French three-factor model.

Keywords: Agency conflicts, Distribution of firms, Financial frictions, Capital allocation, Endogenous growth, Asset pricing.

JEL Classification: L11, O30, O40.

Suggested Citation

Dou, Winston and Ji, Yan and Tian, Di and Wang, Pengfei, Asset Pricing with Misallocation (July 2, 2021). Available at SSRN: https://ssrn.com/abstract=3540012 or http://dx.doi.org/10.2139/ssrn.3540012

Winston Dou (Contact Author)

The Wharton School, University of Pennsylvania ( email )

2318 Steinberg Hall - Dietrich Hall
3620 Locust Walk
Philadelphia, PA 19104
United States

Yan Ji

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

Di Tian

Department of Economics at University of Pennsylvania ( email )

160 McNeil Building
3718 Locust Walk
Philadelphia, PA 19104
United States

Pengfei Wang

Peking University HSBC Business School ( email )

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