A Model of Cross-Section of Equity Returns and Firm Dynamics

We put forward a general equilibrium model that links the cross-section variation of expected returns to firms’ life cycle dynamics. In the model all assets have the same exposure to short-run consumption risks, but di¤er in their exposure to long-run consumption risks (Bansal and Yaron (2004)). An econometrician who uses conditional CAPM regression to predict asset returns will obtain higher for assets with higher exposure to long-run risks. Growth options have lower exposure to long-run risks than assets in place because the cost of exercising the growth options has high exposure to long-run risks and therefore provides a hedge against the risks of assets place. Small firms have higher exposure to long-run risks because they have higher operating leverage.