Equilibrium Cross-Section of Returns

We explicitly link expected stock returns to firm characteristics such as firm size and book-to-market ratio in a dynamic general equilibrium production economy. Despite the fact that stock returns in the model are characterized by an intertemporal CAPM with the market portfolio as the only factor, size and book-to-market play separate roles in describing the cross-section of returns. These firm characteristics appear to predict stock returns because they are correlated with the true conditional market beta of returns. These cross-sectional relations can subsist after one controls for a typical empirical estimate of market beta. This lends support to the view that the documented ability of size and book-to-market to explain the cross-section of stock returns is not necessarily inconsistent with a single-factor conditional CAPM model. Our model also gives rise to a number of additional implications for the cross-section of returns. In this paper, we focus on the business cycle properties of returns and firm characteristics. Our results appear consistent with the limited existing evidence and provide a benchmark for future empirical studies.cycle properties