Firm Heterogeneity in Production-Based Asset Pricing: The Role of Habit Sensitivity and Lumpy Investment

Abstract

I study the interaction between lumpy investment and asset prices in both time-series and cross-section. To this end, I work with a variant of habit sensitivity function introduced in Campbell & Cochrane (1999). The model produces 100% equity volatility of data by generating volatile marginal utility under the assumption of non-convex adjustment costs. Second, the model reproduces nearly 100% equity premiums of data because it assigns large weights on precautionary savings and constrained firms, respectively. Furthermore, the model can rationalise considerable size premiums as small firms absorb more productivity risks. Finally, the model matches key macroeconomic moments and the cross-sectional investment rate.

Keywords: Habit Formation, Lumpy Investment, Firm Heterogeneity, Production-Based Asset Pricing, Size Premiums

JEL Classification: E22, E3, G1