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Resurrecting the (C)CAPM: A CrossSectional Test When Risk Premia Are TimeVarying
 Journal of Political Economy
, 2001
"... This paper explores the ability of conditional versions of the CAPM and the consumption CAPM—jointly the (C)CAPM—to explain the cross section of average stock returns. Central to our approach is the use of the log consumption–wealth ratio as a conditioning variable. We demonstrate that such conditio ..."
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Cited by 139 (5 self)
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This paper explores the ability of conditional versions of the CAPM and the consumption CAPM—jointly the (C)CAPM—to explain the cross section of average stock returns. Central to our approach is the use of the log consumption–wealth ratio as a conditioning variable. We demonstrate that such conditional models perform far better than unconditional specifications and about as well as the FamaFrench threefactor model on portfolios sorted by size and booktomarket characteristics. The conditional consumption CAPM can account for the difference in returns between lowbooktomarket and highbooktomarket portfolios and exhibits little evidence of residual size or booktomarket effects. We are grateful to Eugene Fama and Kenneth French for graciously providing the
Asset pricing at the millennium
 Journal of Finance
"... This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the tradeoff between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor ~SDF! that prices all assets in the economy. The behavior ..."
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Cited by 123 (3 self)
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This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the tradeoff between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor ~SDF! that prices all assets in the economy. The behavior of the term structure of real interest rates restricts the conditional mean of the SDF, whereas patterns of risk premia restrict its conditional volatility and factor structure. Stylized facts about interest rates, aggregate stock prices, and crosssectional patterns in stock returns have stimulated new research on optimal portfolio choice, intertemporal equilibrium models, and behavioral finance. This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work. Theorists develop models with testable predictions; empirical researchers document “puzzles”—stylized facts that fail to fit established theories—and this stimulates the development of new theories. Such a process is part of the normal development of any science. Asset pricing, like the rest of economics, faces the special challenge that data are generated naturally rather than experimentally, and so researchers cannot control the quantity of data or the random shocks that affect the data. A particularly interesting characteristic of the asset pricing field is that these random shocks are also the subject matter of the theory. As Campbell, Lo, and MacKinlay ~1997, Chap. 1, p. 3! put it: What distinguishes financial economics is the central role that uncertainty plays in both financial theory and its empirical implementation. The starting point for every financial model is the uncertainty facing investors, and the substance of every financial model involves the impact of uncertainty on the behavior of investors and, ultimately, on mar* Department of Economics, Harvard University, Cambridge, Massachusetts
Corporate Investment and Asset Price Dynamics: Implications for the CrossSection of Returns
 Journal of Finance
, 2004
"... We show that corporate investment decisions can explain conditional dynamics in expected asset returns. Our approach is similar in spirit to Berk, Green, and Naik (1999), but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth ..."
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Cited by 83 (6 self)
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We show that corporate investment decisions can explain conditional dynamics in expected asset returns. Our approach is similar in spirit to Berk, Green, and Naik (1999), but we introduce to the investment problem operating leverage, reversible real options, fixed adjustment costs, and finite growth opportunities. Asset betas vary over time with historical investment decisions and current product market demand. Booktomarket effects emerge and relate to operating leverage, while size captures the residual importance of growth options relative to assets in place. We estimate and test the model using simulation methods and reproduce portfolio excess returns comparable to the data. Corporate investment decisions are often evaluated in a real options context, 1 and option exercise can change the riskiness of a firm in various ways. For example, if growth opportunities are finite, the decision to invest changes the ratio of growth options to assets in place. Additionally, the resulting increase
Nonlinear Pricing Kernels, Kurtosis Preference, and the CrossSection of Assets Returns
 Journal of Finance
, 2002
"... This paper investigates nonlinear pricing kernels in which the risk factor is endogenously determined and preferences restrict the definition of the pricing kernel. These kernels potentially generate the empirical performance of nonlinear and multifactor models, while maintaining empirical power and ..."
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Cited by 82 (2 self)
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This paper investigates nonlinear pricing kernels in which the risk factor is endogenously determined and preferences restrict the definition of the pricing kernel. These kernels potentially generate the empirical performance of nonlinear and multifactor models, while maintaining empirical power and avoiding ad hoc specifications of factors or functional form. Our test results indicate that preferencerestricted nonlinear pricing kernels are both admissible for the cross section of returns and are able to significantly improve upon linear single and multifactor kernels. Further, the nonlinearities in the pricing kernel drive out the importance of the factors in the linear multifactor model. A PRINCIPAL IMPLICATION OF THE Capital Asset Pricing Model ~CAPM! is that the pricing kernel is linear in a single factor, the portfolio of aggregate wealth. Numerous studies over the past two decades have documented violations of this restriction. 1 In response, researchers have examined the performance of alternative models of asset prices. These models have generally fallen into two classes: ~1! multifactor models such as Ross ’ APT or Merton’s ICAPM, in which factors in addition to the market return determine asset prices; or ~2! nonparametric models, such as Bansal et al. ~1993!, Bansal and Viswanathan ~1993!, and Chapman ~1997!, in which the pricing kernel is not
Explaining the Poor Performance of Consumptionbased Asset Pricing Models
 Journal of Finance
, 2000
"... We show that the external habitformation model economy of Campbell and Cochrane ~1999! can explain why the Capital Asset Pricing Model ~CAPM! and its extensions are better approximate asset pricing models than is the standard consumptionbased model. The model economy produces timevarying expect ..."
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Cited by 54 (4 self)
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We show that the external habitformation model economy of Campbell and Cochrane ~1999! can explain why the Capital Asset Pricing Model ~CAPM! and its extensions are better approximate asset pricing models than is the standard consumptionbased model. The model economy produces timevarying expected returns, tracked by the dividendprice ratio. Portfoliobased models capture some of this variation in state variables, which a stateindependent function of consumption cannot capture. Therefore, though the consumptionbased model and CAPM are both perfect conditional asset pricing models, the portfoliobased models are better approximate unconditional asset pricing models. THE DEVELOPMENT OF CONSUMPTIONBASED ASSET PRICING THEORY ranks as one of the major advances in financial economics during the last two decades. The classic papers of Lucas ~1978!, Breeden ~1979!, Grossman and Shiller ~1981!, and Hansen and Singleton ~1982, 1983! show how a simple relation between consumption ...
Investment Plans and Stock Returns
 Journal of Finance
, 1999
"... When the discount rate falls, investment should rise. Thus with timevarying discount rates and instantly changing investment, investment should positively covary with current stock returns and negatively covary with future stock returns. Aggregate nonresidential U.S. investment contradicts both the ..."
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Cited by 48 (1 self)
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When the discount rate falls, investment should rise. Thus with timevarying discount rates and instantly changing investment, investment should positively covary with current stock returns and negatively covary with future stock returns. Aggregate nonresidential U.S. investment contradicts both these implications, probably because of investment lags. Investment plans, however, satisfy both implications. These investment plans, from a U.S. government survey of firms, are highly informative measures of expected investment and explain more than threequarters of the variation in real annual aggregate investment growth. Plans have substantial forecasting power for excess stock returns, showing that timevarying risk premia affect investment. A BASIC IDEA IN ECONOMICS and finance is that when the discount rate falls, investment should rise. If discount rates move over time and investment instantly adjusts, then the idea has two implications. First, investment and stock returns should positively covary over time. This positive contemporaneous
2003b, Asset Pricing Implications of Firms’ Financing Constraints  Technical Appendix, unpublished manuscript
"... We use a productionbased asset pricing model to investigate whether financial market imperfections are quantitatively important for pricing the crosssection of returns. Specifically, we use GMM to explore the stochastic Euler equation restrictions imposed on asset returns by optimal investment beh ..."
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Cited by 38 (12 self)
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We use a productionbased asset pricing model to investigate whether financial market imperfections are quantitatively important for pricing the crosssection of returns. Specifically, we use GMM to explore the stochastic Euler equation restrictions imposed on asset returns by optimal investment behavior. Our methodology allows us to identify the impact of financial frictions on the stochastic discount factor with cyclical variations in cost of external funds. We find evidence that financing frictions provide an important common factor for the cross section of stock returns. In addition, we find that the shadow price of external funds exhibits strong procyclical variation, so that financial frictions are more important when economic conditions are relatively good. These findings seem consistent with models emphasizing the importance of agency conflicts between insiders and outsiders.
Asset Pricing Implications of NonConvex Adjustment Costs of Investment, Working
, 2002
"... This paper links the firm’s booktomarket ratio and its conditional market beta. If real investment is largely irreversible, the book value of assets of a distressed firm remains fairly constant and its booktomarket ratio is high. Returns on such a firm are sensitive to aggregate conditions. The ..."
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Cited by 32 (1 self)
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This paper links the firm’s booktomarket ratio and its conditional market beta. If real investment is largely irreversible, the book value of assets of a distressed firm remains fairly constant and its booktomarket ratio is high. Returns on such a firm are sensitive to aggregate conditions. The firm’s extra installed capital capacity allows it to expand production easily in response to a positive aggregate shock without undertaking any costly investment, yielding a large payoff to the equity holders. In contrast, a low booktomarket firm must undertake investment in order to fully benefit from the shock. Thus, high booktomarket firms have a higher systematic risk. The paper provides empirical evidence that supports the time series predictions of the model. I am grateful to my committee members John Heaton, Owen Lamont, Toby Moskowitz and especially Steve Davis and George Constantinides for their guidance and encouragement. This paper has also
The value premium
 Journal of Finance
, 2005
"... The value anomaly arises naturally in the neoclassical framework with rational expectations. Costly reversibility and countercyclical price of risk cause assets in place to be harder to reduce, and hence are riskier than growth options especially in bad times when the price of risk is high. By linki ..."
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Cited by 31 (2 self)
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The value anomaly arises naturally in the neoclassical framework with rational expectations. Costly reversibility and countercyclical price of risk cause assets in place to be harder to reduce, and hence are riskier than growth options especially in bad times when the price of risk is high. By linking risk and expected returns to economic primitives, such as tastes and technology, my model generates many empirical regularities in the crosssection of returns; it also yields an array of new refutable hypotheses providing fresh directions for future empirical research. WHY DO VALUE STOCKS EARN HIGHER EXPECTED RETURNS than growth stocks? This appears to be a troublesome anomaly for rational expectations, because according to conventional wisdom, growth options hinge upon future economic conditions and must be riskier than assets in place. In a widely used corporate finance textbook, Grinblatt and Titman (2001, p. 392) contend that “Growth opportunities are usually the source of high betas,..., because growth options tend to be most valuable in good times and have implicit leverage, which tends to increase