The Asset Pricing Implications of Financial Shocks for the Cross Section of Returns: Theory and Measurement

Abstract

This paper studies the financial sources of aggregate risks and their impact for the cross section of asset prices. We show that in a dynamic general equilibrium model with frictions in both equity and debt markets, shocks to the costs of external equity and debt issuances, affect households' marginal utility and hence the stochastic discount factor. To capture the aggregate variations in equity and debt financing costs, we construct equity and debt issuance shocks as the unexpected changes to the fractions of issuing firms controlling for observable proxies of costs of equity and debt. The two financial shocks joint with the market factor can capture the cross-sectional variations of a number of hard-to-explain assets including, 1) the value premium and the momentum portfolios simultaneously, 2) the q-factors and their benchmark portfolio returns, and 3) the corporate bond portfolios.

Keywords: financial shocks, value premium, momentum, q-factor, financial frictions

JEL Classification: E22, E44, G12