Two Risk Factors in the Long Run : A Key to Decipher Asset Pricing Puzzles

We propose a consumption-based capital asset pricing model (CCAPM) with both aggregate and investment-specific technological changes to identify two risk factors that drive the consumption dynamics and asset prices in the long run. These two long-run risk factors capture the two types of technological changes and help to explain the asset pricing puzzles that the five-factor model of Fama and French (2015) fails to explain. More specifically, small firms that invest a lot despite low profitability earn low average returns because their cash flows provide a good hedge to the consumption risk orthogonal to investment risk in the long run. In contrast, large firms that invest despite low profitability earn higher average returns as their cash flows correlate positively with the long-run consumption risk. Furthermore, the long-run prices of risks and risk exposures of cash flows change after 2000