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Discount rates, market frictions and the mystery of the size premium

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  • Thiago de Oliveira Souza

Abstract

I document the empirical evidence showing that the size premium only exists when the median book-to-market ratios in the market is high. I argue that this evidence supports the hypothesis that the size effect is a consequence of market frictions and not a risk factor priced in equilibrium. High discount rates lower stock valuations and increase the overall book-to-market ratios in the market. They are also associated with the low risk bearing capacity, limited risk sharing and high uncertainty that increase market frictions. Ranking the years in book-to-market quantiles, as a proxy for discount rates, reveals that the size premium is usually statistically significant exclusively in the top book-to-market quantile. This evidence is robust to changes in the number of quantiles; in the US in different sub periods, and in the UK; considering both the Fama/French SMB factor or the individual size portfolios; and also controlling for market risk.

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File URL: ftp://ideas.repec.org/pub/RePEc/jmp/files/2013/pde868JMP-Souza.pdf
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Paper provided by Job Market Papers in its series 2013 Papers with number pde868.

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Date of creation: 29 Nov 2013
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Handle: RePEc:jmp:jm2013:pde868

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  1. Bruno Strulovici & Darrell Duffie, 2009. "Capital Mobility and Asset Pricing," 2009 Meeting Papers 87, Society for Economic Dynamics.
  2. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
  3. Fama, Eugene F. & French, Kenneth R., 2012. "Size, value, and momentum in international stock returns," Journal of Financial Economics, Elsevier, vol. 105(3), pages 457-472.
  4. Clifford S. Asness & Tobias J. Moskowitz & Lasse Heje Pedersen, 2013. "Value and Momentum Everywhere," Journal of Finance, American Finance Association, vol. 68(3), pages 929-985, 06.
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