Essays on the cross-section of returns
My dissertation aims at understanding the economic determinants of the cross-section of equity returns. It contains three chapters. Chapter One constructs a dynamic general equilibrium production economy to explicitly link expected stock returns to firm characteristics such as firm size and the book-to-market ratio. 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. However, these firm characteristics appear to predict stock returns only because they are correlated with the true conditional market beta. Moreover, quantitative analysis suggests that these cross-sectional relations can subsist even 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 consistent with a single-factor conditional CAPM model. Chapter Two asks whether firms' financing constraints are quantitatively important in explaining asset returns. It has two main findings. First, for a large class of theoretical models, financing constraints have a parsimonious representation amenable to empirical analysis. Second, financing frictions lower both the market Sharpe ratio and the correlation between the pricing kernel and returns. Consequently, they significantly worsen the performance of investment-based asset pricing models. These findings question whether financing frictions are important for explaining the cross-section of returns and whether they provide a realistic propagation mechanism in several macroeconomic models. Chapter Three proposes a novel economic mechanism underlying the value premium, the average return difference between value and growth stocks in the cross-section. The key element emphasized is the asymmetric adjustment cost of capital. During recessions, value firms face more difficulty than growth firms in downsizing capital, and hence their dividend streams fluctuate more with economic downturns. The upshot is that value stocks are more risky than growth stocks in bad times. An industry equilibrium model shows that this mechanism, when combined with a countercyclical market price of risk, goes a long way in generating a value premium that is quantitatively comparable to that observed in the data.
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