Productivity-Based Asset Pricing: Theory and Evidence

This paper considers asset pricing from the production side. It differs from earlier approaches to production-based asset pricing in that the pricing kernel is derived by replacing the marginal rate of intertemporal substitution with an amended version of the marginal rate of intertemporal transformation in a complete markets economy. Relying on a general version of the traditional Real Business Cycle macro model we find that the variables determining the mean returns of all financial assets are the productivity shock as the sole factor together with the capital stock and lagged Solow residual (productivity level) as conditioning variables. Standard GMM estimation finds that our model improves on the complementary consumption-based and market-based approaches and is competitive with the Fama-French three-factor model. The model explains the size premium from differences in the unconditional sensitivity to productivity shocks—small firms are more sensitive to productivity shocks—and explains the value premium from differences in the conditional sensitivity to productivity shocks—growth stocks are more sensitive to productivity shocks in good states when the risk premium is low.