Capital Allocation Based Asset Pricing

1 Pages Posted: 29 Jan 2021

Date Written: November 12, 2017

Abstract

I explore an intricate interaction between a firm’s risk exposure, intangible capital accumulation, and physical capital accumulation by using a unified dynamic investment model of capital allocation. The model emphasizes both the importance of the marginal value of the intangible capital and the idiosyncratic risk for corporate decisions, then implicates the firm value and expected returns. A model feature that the good idiosyncratic volatility is endogenously generated, but bad idiosyncratic volatility does not. The model provides several implications: (1) high bad idiosyncratic volatility lowers the firm’s profitability, expected returns, and Tobin’s q due to risk management and capital misallocation. Typically, this effect is much stronger in value firms; (2) there is a positive interaction between the value effect, profitability effect, and momentum. The idiosyncratic volatility can also affect the other anomalies indirectly via a complicated interaction between the corporate investment, internal capital allocation, and risk management, which implies that the idiosyncratic risk is priced indirectly as well; (3) high-tech firm invests more in intangible capital, holds more cash, and finds it much harder to achieve its growth firm region than low-tech firm. This result applies to firms with high idiosyncratic volatility as well.

Keywords: Investment, internal capital allocation, investment-specific technology change, risk management, anomaly, capital allocation based-asset pricing theory

JEL Classification: G12, G30, G31, G34, G35, O32, O33

Suggested Citation

Qi, Qian, Capital Allocation Based Asset Pricing (November 12, 2017). Available at SSRN: https://ssrn.com/abstract=3747604 or http://dx.doi.org/10.2139/ssrn.3747604

Qian Qi (Contact Author)

Peking University ( email )

No. 38 Xueyuan Road
Haidian District
Beijing, Beijing 100871
China

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