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Investment and Returns

74 Pages Posted: 24 Mar 2005  

Vito Gala

The Wharton School

Date Written: November 2005


This paper constructs a general equilibrium production economy with heterogeneous firms and irreversible investment that rationalizes the value premium. Firm investments play a central role in explaining the cross-sectional variation of stock returns. Profitable and fast growing growth firms have low expected returns because they provide consumption insurance to investors, especially in bad times. Countercyclical consumption volatility generates a larger value premium during recessions. Large firms grow more slowly, so the value premium is larger for small stocks. The model can replicate the failure of the unconditional CAPM and the relative success of the conditional CAPM and Fama and French (1993) factor model.

Keywords: Asset Pricing, Production, Investment, General Equilibrium

JEL Classification: G12, D91, D92, D51, C68, D21, D24

Suggested Citation

Gala, Vito, Investment and Returns (November 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: or

Vito D. Gala (Contact Author)

The Wharton School ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

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