Habit formation,the cross section of stock returns and the cash-flow risk puzzle |
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Authors: | Tano Santos Pietro Veronesi |
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Institution: | 1. Columbia University, CEPR and NBER, USA;2. University of Chicago, CEPR and NBER, USA |
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Abstract: | 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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Keywords: | Habit Value premium Cross-section Cash-flow risk |
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