Operating Hedge and Gross Profitability Premium |
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| Authors: | LEONID KOGAN JUN LI HAROLD H ZHANG |
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| Institution: | 1. Correspondence: Jun Li, Jindal School of Management, University of Texas at Dallas, 800 W. Campbell Rd., Richardson, TX 75080, USA;2. e-mail: jun.li3@utdallas.edu.;3. Kogan is with NBER and MIT Sloan School of Management. Li and Zhang are with Jindal School of Management, University of Texas at Dallas. We are indebted to Stefan Nagel (the Editor), an anonymous Associate Editor, two anonymous referees for highly valuable comments and suggestions that significantly improve the paper. We thank Rajesh Aggarwal;4. Hengjie Ai;5. Ulf Axelson;6. Frederico Belo;7. Philip Bond;8. David Chapman;9. Hui Chen;10. Joseph Chen;11. Jaewon Choi;12. Andres Donangelo;13. Winston Dou;14. Itamar Drechsler;15. Stefano Giglio;16. Jack Favilukis;17. Joao Gomes;18. Harrison Hong;19. Ralph Koijen;20. Christian Heyerdahl Larsen;21. Kai Li;22. Xiaoji Lin;23. Erik Loualiche;24. Deborah Lucas;25. Matteo Maggiori;26. Timothy McQuade;27. Mamdouh Medhat;28. Tyler Muir;29. Stijn Van Nieuwerburgh;30. Nick Roussanov;31. Larry Schmidt;32. Antoinette Schoar;33. David Thesmar;34. Laura Veldkamp;35. Jessica Wachter;36. Neng Wang;37. Michael Weber;38. Toni Whited;39. Wei Xiong;40. Amir Yaron;41. Lu Zhang;42. Miao (Ben) Zhang;43. Haoxiang Zhu;44. seminar participants at Cambridge University, MIT Sloan, Wharton, London School of Economics, Texas A&M University, Northeastern University, University of Oklahoma, Australian National University, Tsinghua PBC School of Finance, Peking University, Remin University, and Shanghai Advanced Institute of Finance;45. and participants of the American Finance Association Annual Meeting, SFS Cavalcade, Western Finance Association Meeting, China International Conference in Finance, 2nd Corporate Policies and Asset Prices Conference, 2019 Annual Conference on Financial Economics and Accounting, Swedish House of Finance conference on Financial Markets and Corporate Decisions, Conference on Frontiers of Quantitative Finance by Jacobs Levy Equity Management Center, and Midwest Finance Association Annual Meeting for helpful discussions. All remaining errors are our own. We have read The Journal of Finance disclosure policy and have no conflicts of interest to 46. disclose. |
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| Abstract: | We show theoretically that variable production costs reduce systematic risk of firms' cash flows if capital and variable inputs are complementary in firms' production and input prices are procyclical. In our dynamic model, this operating hedge effect is weaker for more profitable firms, giving rise to a gross profitability premium. Moreover, gross profitability and value factors are distinct and negatively correlated, and their premia are not captured by the capital asset pricing model (CAPM). We estimate the model by simulated method of moments, and find that its main implications for stock returns and cash flow dynamics are quantitatively consistent with the data. |
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