Equilibrium Cross Section of Returns

TLDR

Stock returns in the model are completely characterized by a conditional capital asset pricing model (CAPM). The study constructs a dynamic general equilibrium production economy to link expected stock returns to firm characteristics such as firm size and book‑to‑market ratio. The model explicitly links expected stock returns to firm characteristics within a dynamic general equilibrium framework. Size and book‑to‑market are correlated with the true conditional market beta and therefore predict stock returns, and these relations persist even after controlling for typical empirical beta estimates, suggesting that the empirical success of size and book‑to‑market can be consistent with a single‑factor conditional CAPM model.

Abstract

We construct 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. Stock returns in the model are completely characterized by a conditional capital asset pricing model (CAPM). Size and book‐to‐market are correlated with the true conditional market beta and therefore appear to predict stock returns. The cross‐sectional relations between firm characteristics and returns can subsist even after one controls for typical empirical estimates of beta. These findings suggest that the empirical success of size and book‐to‐market can be consistent with a single‐factor conditional CAPM model.