Asset Pricing with Misallocation

Abstract

We develop an endogenous growth model with heterogeneous firms facing financial frictions, in which misallocation emerges explicitly as a crucial state variable. In equilibrium, misallocation endogenously generates long-run uncertainty about economic growth by distorting innovation decisions, leading to significant welfare losses and risk premia in capital markets. Macroeconomic shocks that affect misallocation are likely to have overly persistent effects on aggregate growth. Using an empirical misallocation measure motivated by the model, we find evidence showing that misallocation captures low-frequency variations in both aggregate growth and stock returns. 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, Misallocation, Endogenous growth, Macro finance.

JEL Classification: L11, O30, O40.