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

Abstract

I argue that the lumpiness of firm investment behavior matters for asset prices, in both the time-series and cross-section. I propose a production-based asset pricing model which reproduces nearly 100\% of both the observed equity premium and its volatility through large volatility in marginal utility. Incorporating the habit reversal behavior into the positive habit formation in the Campbell-Cochrane preferences is essential to generate this volatile marginal utility. In the cross-section, small and non-adjusting firms earn larger equity premiums than big and adjusting firms when the capital adjustment costs are shaped to respect the evidence on lumpy distribution of firm investment.

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

JEL Classification: E22, E3, G1