Abstract: | Fama and French (1992) show that size and book-to-price dominateCAPM beta and other variables such as the price-earnings ratioand dividend yield in explaining the cross-section of US stockreturns. Comparable evidence for the UK points to a book-to-priceeffect, but not a size effect (Chan and Chui, 1996; Strong andXu, 1997). In this paper, our first contribution is to showthat a measure of research and development (RD) helps explaincross-sectional variation in UK stock returns. Our cross-sectionalresults on the association between stock returns and RD areconsistent with recent US evidence reported by Lev and Sougiannis(1996, 1999) and Chan, Lakonishok and Sougiannis (2001).Famaand French (1993, 1995, 1996) also show that a three-factormodel captures a high proportion of the time series variationin portfolio returns, again for the US. Our second contributionis to show, for the UK, that a modification to the three-factormodel to take account of RD activity can significantly enhancethe explanatory power of the three-factor model. We show that,as a practical matter, estimated risk premia based on the modifiedthree-factor model can differ considerably from risk premiaestimated using the CAPM or the three-factor model. In particular,risk premia for industries in which few firms undertake RD activitiestend to be over-estimated. |