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Habit formation, the cross section of stock returns and the cash-flow risk puzzle

  • Santos, Tano
  • Veronesi, Pietro
Registered author(s):

    Non-linear external habit persistence models, which feature prominently in the recent "equity premium" asset pricing and macroeconomics literature, generate counterfactual predictions in the cross-section of stock returns. In particular, we show that in the absence of cross-sectional heterogeneity in firms' cash-flow risk, these models produce a "growth premium," that is, stocks with high price-to-fundamental ratios command a higher premium than stocks with low price-to-fundamental ratios. This implication is at odds with the well-established empirical observation of a "value premium" in the cross-section of stock returns. Substantial heterogeneity in firms' cash-flow risk yields both a value premium as well as most of the stylized facts about the cross-section of stock returns, but it generates a "cash-flow risk puzzle": Quantitatively, value stocks have to have "too much" cash-flow risk compared to the data to generate empirically plausible value premiums.

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    File URL: http://www.sciencedirect.com/science/article/B6VBX-506RN62-1/2/278dbae7b1bfec26bdf2e204c66be99b
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    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 98 (2010)
    Issue (Month): 2 (November)
    Pages: 385-413

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    Handle: RePEc:eee:jfinec:v:98:y:2010:i:2:p:385-413
    Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

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