DP3482 Equilibrium Cross-Section of Returns

Author(s): Joao F Gomes, Leonid Kogan, Lu Zhang
Publication Date: August 2002
Keyword(s): beta, size and book-to-market factors, business cycle properties of stock returns, CAPM, production based asset pricing
JEL(s): E22, E44, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3482

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 ß of returns. These cross-sectional relations can subsist after one controls for a typical empirical estimate of market ß 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.