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Firms’ Heterogeneous Sensitivities to the Business Cycle, and the Cross-Section of Expected Returns

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  • François Gourio

    () (Department of Economics, Boston University)

Abstract

In this paper, I propose and test a simple technology-based theory of firms’ sensitivities to aggregate shocks. I show that when the elasticity of substitution between capital and labor is below unity, low profitability firms are more sensitive to aggregate shocks, i.e. to the business cycle. Since the wage is smoother than productivity, revenues are more procyclical than costs, making profits, the residual procyclical. Firms with low profitability are more procyclical since the residual is smaller and the amplification greater. I study the asset pricing implications of this technology and find that it can explain the riskiness of small and “value” firms (Fama and French 1996). These firms are less profitable and are thus more procyclical. I find empirically that the cross-section of expected returns is well explained by differences in sensitivities of firms’ earnings to GDP growth, or by differences in profitability. The model yields rich empirical implications by linking a firm’s real behavior (the elasticity of output, employment and profits to an aggregate shock) to its financial characteristics (the firm’s betas and its average return). I next embed my partial equilibrium model in a full DSGE model to conduct a GE analysis. Empirically I show that firms with low margins are indeed more sensitive to the business cycle in their employment, sales or profits.

Suggested Citation

  • François Gourio, 2006. "Firms’ Heterogeneous Sensitivities to the Business Cycle, and the Cross-Section of Expected Returns," Boston University - Department of Economics - Working Papers Series WP2006-005, Boston University - Department of Economics.
  • Handle: RePEc:bos:wpaper:wp2006-005
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Gourio, Francois & Kashyap, Anil K, 2007. "Investment spikes: New facts and a general equilibrium exploration," Journal of Monetary Economics, Elsevier, vol. 54(Supplemen), pages 1-22, September.
    2. Hengjie Ai & Dana Kiku, 2008. "A Model of Cross-Section of Equity Returns and Firm Dynamics," 2008 Meeting Papers 1030, Society for Economic Dynamics.
    3. Mariano Max Croce, 2010. "Tax Uncertainty, Leverage and Asset Prices," 2010 Meeting Papers 1084, Society for Economic Dynamics.
    4. Ai, Hengjie & Kiku, Dana, 2013. "Growth to value: Option exercise and the cross section of equity returns," Journal of Financial Economics, Elsevier, vol. 107(2), pages 325-349.

    More about this item

    Keywords

    Cross-Section of Returns; Book-to-Market; Value Premium; Productivity Heterogeneity.;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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