The Journal of Finance - 2005 - ZHANG - The Value Premium

THE JOURNAL OF FINANCE • VOL. LX, NO.
1 • FEBRUARY 2005
The Value Premium
LU ZHANG∗
ABSTRACT
The value anomaly arises naturally in the neoclassical framework with rational ex-
pectations. 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 eco-
nomic primitives, such as tastes and technology, my model generates many empirical
regularities in the cross-section 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 ap-
pears 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 opportuni-
ties 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
beta, they contain a great deal of systematic risk.” Gomes, Kogan, and Zhang
(2003) also predict that growth options are always riskier than assets in place,
as these options are “leveraged” on existing assets. Growth stocks, which derive
market values more from growth options, must therefore be riskier than value
stocks, which derive market values more from assets in place. Yet, historically,
growth stocks earn lower average returns than value stocks.
I investigate how risk and expected return are determined by economic prim-
itives, such as tastes and technology, in the neoclassical framework with ratio-
nal expectations and competitive equilibrium (e.g., Kydland and Prescott (1982)
and Long and Plosser (1983)). A workhorse of many fields of economics, this
framework has been under strenuous attack in finance (e.g., Shleifer (2000)).
∗ William E. Simon Graduate School of Business Administration, University of Rochester. This

paper is based on chapter three of my doctoral dissertation at the Wharton School of the University
of Pennsylvania. I thank my advisors Andrew Abel, Craig MacKinlay, Amir Yaron, and especially
Joao Gomes for their training and inspiration. I also acknowledge helpful comments from Michael
Brandt, Domenico Cuoco, Kent Daniel, Gary Gorton, Rick Green (the editor), Skander Van den
Heuvel, Ming Huang, Donald Keim, Leonid Kogan, Martin Lettau, Ralitsa Petkova, Nick Souleles,
Robert Stambaugh, Yunguang Yang, and participants at numerous workshops. I am especially
indebted to an anonymous referee for many constructive criticisms. Naiping Liu taught me how
to build Fortran 90 MEX routines in Matlab. Financial support from the Dean’s Fellowship for
Distinguished Merits at the Wharton School is gratefully acknowledged. All remaining errors are
my own.
67
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68 The Journal of Finance
Yet, despite frequent claims of inefficient markets, what is missing, it seems,

is a clear delineation of what the neoclassical world implies about risk and
expected return. Filling this gap seems extremely important.
I demonstrate that, contrary to the conventional wisdom, assets in place are
much riskier than growth options, especially in bad times when the price of
risk is high. This mechanism can potentially explain the value anomaly, a high
spread in expected return between value and growth strategies even though
their spread in unconditional market beta is low.
My explanation relies on two salient features of the model, costly reversibility
and countercyclical price of risk. Costly reversibility implies that firms face
higher costs in cutting than in expanding capital.1 Through optimal capital
investment, this asymmetry gives rise to cyclical behavior of value and growth
betas.
In bad times, value firms are burdened with more unproductive capital,
finding it more difficult to reduce their capital stocks than growth firms do.
The dividends and returns of value stocks will hence covary more with eco-
nomic downturns. In good times, growth firms invest more and face higher
adjustment costs to take advantage of favorable economic conditions. Expand-
ing capital is less urgent for value firms since their previously unproductive
capital now becomes productive. As expanding capital is relatively easy, the
dividends and returns of growth firms do not covary much with economic
booms. The net effect is a high dispersion of risk between value and growth
strategies in bad times and a low or even negative dispersion of risk in good
times.
Costly reversibility is also consistent with a low unconditional dispersion
of risk between value and growth. Bad times characterized by disinvestment
occur less often and last for shorter periods than good times. A low unconditional
dispersion of risk arises, as high positive dispersion of risk in bad times is offset
by low or even negative dispersion in good times.
With rational expectations, the value premium equals the risk dispersion
between value and growth times the price of risk. When the price of risk is
constant, the average value premium must be accounted for entirely by the
unconditional beta dispersion. This seems at odds with the empirical evidence
in Fama and French (1992).2 It is well known that time-varying price of risk
1
Abel and Eberly (1994, 1996) study firms’ optimal investment with costly reversibility in a
partial equilibrium setting. Ramey and Shapiro (2001) provide direct empirical evidence for costly
reversibility. A large portion of the literature on capital investment is devoted to examining the
implications of a special case of costly reversibility, that is, irreversible investment, which says
that the cost of cutting capital is infinite so that investment can never be negative. Dixit and
Pindyck (1994) survey the literature on irreversible investment and Kogan (2000, 2001) examines
the implications of irreversibility on investment and time-varying return volatility in a two-sector
general equilibrium model.
2
However, Petkova and Zhang (2003) show, using the longer sample from 1927 to 2001 than the
short sample from 1963 to 1991 used by Fama and French (1992), that the unconditional market
beta spread between value and growth is 0.41, much higher than the effective zero reported by
Fama and French.
The Value Premium 69
improves the performance of the conditional asset pricing models; my contribu-

tion is to analyze the impact of this time-variation on capital investment and
expected return within the neoclassical framework.
I find that because discount rates are higher in bad times with the counter-
cyclical price of risk, firms’ expected continuation values are on average lower
than those with constant price of risk. Value firms want to disinvest even more
in bad times. The time-varying price of risk thus interacts with and propagates
the effect of asymmetry, resulting in a high average value premium, more than
the amount attributable to the unconditional dispersion of risk alone.
By linking risk and expected return to economic primitives my model pro-
vides a unified framework to rationalize many empirical regularities in the
cross-section of returns in relation to the value premium: (i) Value is riskier
than growth, especially in bad times when the price of risk is high (Lettau
and Ludvigson (2001), Petkova and Zhang (2003)); (ii) high book-to-market sig-
nals persistently low profitability and low book-to-market signals persistently
high profitability (Fama and French (1995)); (iii) the expected value premium
is atypically high at times when the value spread (in book-to-market) is wide
(Cohen, Polk, and Vuolteenaho (2003)); and (iv) the earnings growth spread
between value and growth is a positive predictor of the value-minus-growth
return (Asness et al. (2000)).3 In contrast, it is not clear how these patterns can
be explained by the behavioral overreaction hypothesis advocated by DeBondt
and Thaler (1985) and by Lakonishok, Shleifer, and Vishny (1994), since it is
relatively detached from economic fundamentals.
Finally, the model also yields a rich array of new refutable hypotheses pro-
viding fresh directions for future empirical research:4 (i) Value firms disinvest
more than growth firms in bad times, and growth firms invest more than value
firms in good times; (ii) the expected value premium and the value spread are
both countercyclical; (iii) the degree of asymmetry correlates positively with
the expected value premium across industries; (iv) the industry cost of capi-
tal increases with the industry book-to-market and the cross-sectional disper-
sion of individual stock returns within the industry; and finally, (v) the de-
gree of asymmetry correlates positively with the industry cost of capital across
industries.
My work is related to that of Berk, Green, and Naik (1999), who construct a
dynamic real options model in which assets in place and growth options change
in predictable ways. This pattern in turn imparts predictability in risk and
expected returns. The real options model in Berk et al. features exogenous
project-level cash f low and systematic risk. My neoclassical model differs in that
all firm-level variables, except for the exogenous idiosyncratic productivity, are
determined endogenously in competitive equilibrium. My model can therefore
shed light on more fundamental determinants of firm-level cash f low, risk, and
expected return.
3
The model in Gomes et al. (2003) can also generate patterns (ii) and (iii) but through different
economic mechanisms. See Section II.C for more discussion on that paper.
4
Schwert (2003) highlights the importance for structural models to derive new testable hypothe-
ses and go beyond the stage of explaining the existing stylized facts.
Gomes et al. (2003) represent another theoretical attempt to link risk and ex-
pected returns to size and book-to-market in a dynamic equilibrium model. My
work differs primarily in its explanation of the value premium. Gomes et al.
assume that all firms have equal growth options, implying that investment
plans are independent of current productivity. Since more profitable growth
firms cannot invest more, by construction, they have to pay out more divi-
dends. Growth firms have shorter cash-f low duration than value firms. This is
counterfactual.5 Gomes et al. then rely on this pattern to generate a positive
expected value premium, based on equity duration risk (e.g., Cornell (1999)).
By relaxing the equal-growth assumption, my model allows firms to condition
investment plans optimally on their current productivity. A new mechanism
for the value premium arises, as asymmetry and the countercyclical price of
risk cause assets in place to be harder to reduce, and hence to be riskier than
growth options especially in bad times when the price of risk is high.
The outline for the rest of the paper is as follows. The equilibrium investment
model is constructed in Section I. I present the main findings concerning the
value premium in Section II and explore other model predictions in Section III.
Section IV brief ly discusses the related literature. Finally, Section V concludes.
I. The Model
I construct a neoclassical industry equilibrium model (e.g., Lucas and Prescott
(1971)) augmented with aggregate uncertainty.6 Section I.A describes the eco-
nomic environment. Section I.B presents the value-maximizing behavior of
firms. I then discuss aggregation in Section I.C and define the competitive
equilibrium in Section I.D. Appendix A contains the proofs and Appendix B
outlines the solution methods.
A. Environment
The industry is composed of a continuum of competitive firms that produce
a homogeneous product. Firms behave competitively, taking the price in the
product market as given.
A.1. Technology
Production requires one input, capital, k, and is subject to both an aggregate
shock, x, and an idiosyncratic shock, z. The next two assumptions concern the
nature of the productivity shocks:
5
Smith and Watts (1992) document that high book-to-market firms are more likely to pay out
dividends. Dechow, Sloan, and Soliman (2002) report that equity duration is strongly negatively
correlated with book-to-market.
6
Most of the extant industry equilibrium models abstract from aggregate uncertainty. Examples
include Hopenhayn (1992), Cooley and Quadrini (2001), and Gomes (2001).
ASSUMPTION 1: The aggregate productivity shock has a stationary and monotone

Markov transition function, denoted by Qx (xt+1 | xt ), as follows:
xt+1 = x(1 − ρx ) + ρx xt + σx εt+1

x
, (1)
where εt+1
x
is an IID standard normal shock.
ASSUMPTION 2: The idiosyncratic productivity shocks, denoted by zjt , are uncor-

related across firms, indexed by j, and have a common stationary and monotone
Markov transition function, denoted by Qz (zjt+1 | zjt ), as follows:
z j t+1 = ρz z j t + σz ε zjt+1 , (2)
where εjt+1
z
is an IID standard normal shock and εjt+1 z
and εit+1
z
are uncorrelated
for any pair (i, j) with i = j. Moreover, εt+1 is independent of εjt+1
x z
for all j.
Both aggregate and idiosyncratic shocks are necessary to generate a nontriv-

ial cross-section of returns. I clearly need aggregate uncertainty, otherwise all
firms in the economy will ex ante earn exactly the risk-free rate. I also need an
idiosyncratic shock to generate firm heterogeneity in the model.
The production function is given by
y j t = e xt +z j t k αj t , (3)
where 0 < α < 1, and yjt and kjt are the output and capital stock of firm j at
period t, respectively. The production technology exhibits decreasing-return-to-
scale.
A.2. Stochastic Discount Factor

I follow Berk et al. (1999) and parameterize directly the pricing kernel with-
out explicitly modeling the consumer’s problem. Since my focus is on the pro-
duction side, this strategy seems reasonable. I assume the pricing kernel to
be
log M t+1 = log β + γt (xt − xt+1 ) (4)
γt = γ0 + γ1 (xt − x), (5)
where Mt+1 denotes the stochastic discount factor from time t to t + 1. The
notations β, γ0 > 0, and γ1 < 0 are constant parameters.
Equation (4) can be motivated as follows. Suppose there is a fictitious con-
sumer side of the economy featuring one representative agent with power util-
ity and a relative risk averse coefficient, A. The log pricing kernel is then
log Mt+1 = log β + A(ct − ct+1 ), where ct denotes log aggregate consumption.
Since I do not solve the consumer’s problem that would be necessary in a gen-
eral equilibrium, I can link ct to the aggregate state variable in a reduced-form
way by letting ct = a + bxt with b > 0.7 Equation (4) now follows immediately
by defining γt to be Ab.
It is well known that power utility has many limitations, one of which is
that it implies a constant price of risk, given an exogenous, homoscedastic con-
sumption growth process. I thus assume in (5) that γt is time-varying and de-
creasing with the demeaned aggregate productivity xt − x, where γ1 < 0. I re-
main agnostic about the precise economic sources of the countercyclical price of
risk.8
A.3. Industry Demand

The inverse industry demand function is denoted by P(Yt ), where Pt is the
output price and Yt is the total output in the industry at time t. I follow Caballero
and Pindyck (1996) and parameterize P(·) as
−η
P (Y t ) = Y t , (6)
where 0 < η < 1 and 1/η can be interpreted as the price elasticity of demand.
B. Firms
I now summarize the decisions of firms. The timing of events is standard.
Upon observing the shocks at the beginning of period t, firms make optimal
investment decisions.
B.1. Value Maximization

I suppress the firm index j for notational simplicity. The profit function for
an individual firm with capital stock kt and idiosyncratic productivity zt , facing
aggregate shock xt and log output price pt ≡ log Pt , is
π(kt , z t ; xt , pt ) = e xt +z t + pt ktα − f , (7)
where f denotes the nonnegative fixed cost of production, which must be paid
every period by all the firms in production. A positive fixed cost captures the
existence of fixed outside opportunity costs for some scarce resources such as
managerial labor used by the firms.
7
Since there exists a large number of firms, the law of large numbers implies that firm-specific
shocks do not affect the aggregate consumption. Moreover, the stationarity of the economy implies
that the level of aggregate capital stock affects consumption only indirectly through aggregate
shock, given the initial level of aggregate capital.
8
The specific functional form of the kernel relates naturally to the time-varying risk aversion in
Campbell and Cochrane (1999). Other possibilities include loss aversion in Barberis, Huang, and
Santos (2001) and limited market participation in Guvenen (2002).
Let v(kt , zt ; xt , pt ) denote the market value of the firm. I can use Bellman’s
principle of optimality to state the firm’s dynamic problem as

v(kt , z t ; xt , pt ) = max π (kt , z t ; xt , pt ) − it − h(it , kt )
kt+1 ,it

+ M t+1 v(kt+1 , z t+1 ; xt+1 , pt+1 )Q z (d z t+1 | z t )Q x (d xt+1 | xt ) ,
(8)
subject to the capital accumulation rule
kt+1 = it + (1 − δ)kt , (9)
where it denotes investment at time t and δ is the constant depreciation rate.

The first three terms in the right-hand side of (8) ref lect current dividend,
denoted by dt , i.e., profit π minus investment, i, minus adjustment cost, h.
Following Lucas (1967), I model adjustment cost directly as a deduction from
the profit function. The functional form of h is asymmetric and quadratic:
2
θt it
h(it , kt ) ≡ kt , (10)
2 kt
where
θt ≡ θ + · χ{it ≥0} + θ − · χ{it <0} (11)
and χ{·} is the indicator function that equals one if the event described in {·}
is true and zero otherwise. Figure 1 provides a graphical illustration of the
specification of h.
The quadratic adjustment cost is standard in the Q-theoretical literature of
investment. I model the adjustment cost to be asymmetric also, that is, θ − >
θ + > 0, to capture the intuition of costly reversibility in Abel and Eberly (1994,
1996). Firms face higher costs per unit of adjustment in contracting than in
expanding their capital stocks.9
B.2. Beta and Expected Return

PROPOSITION 1: The risk and expected return of firm j satisfy
Et [R j t+1 ] = R f t + β j t λmt , (12)
where Rft is the real interest rate and the stock return is defined as
R j t+1 ≡ vj t+1 /(vj t − d j t ) (13)
9
Hall (2001) uses a similar formulation of asymmetric adjustment cost in an investigation of
stock market in relation to aggregate corporate investment.
Figure 1. Asymmetric adjustment cost. This figure illustrates the specification of capital ad-
justment cost, equations (10) and (11). The investment rate, i/k, is on the x-axis and the amount
of adjustment cost, h(i, k), is on the y-axis. The adjustment cost is assumed to be
2
θt it
h(it , kt ) = kt ,
2 kt
where
θt ≡ θ + · χ{it ≥0} + θ − · χ{it <0}
and χ{·} is an indicator function that equals one if the event described in {·} is true and zero
otherwise. Moreover, θ − > θ + > 0, implying that firms face higher costs in adjusting capital stocks
downward than upward.
and djt is the dividend at time t, djt ≡ πjt − ijt − h(ijt , kjt ).10 The quantity of risk
is given by
β j t ≡ −Covt [R j t+1 , M t+1 ]/Vart [M t+1 ] (14)
and the price of risk is given by
λmt ≡ Vart [M t+1 ]/Et [M t+1 ]. (15)
10
Note that v(kjt , zjt , xt , pt ) is the cum dividend firm value, in that it is measured before dividend
is paid out. Define vjet ≡ vj t − d j t to be the ex dividend firm value, then Rjt+1 reduces to the usual
definition Rjt+1 = (vjt+1
e
+ djt+1 )/vejt .
Proof: See Appendix A.
C. Aggregation
Having described the optimization behavior of firms, I am now ready to char-
acterize the aggregate behavior of the industry. The output price will be deter-
mined in the competitive equilibrium to equate industry demand and supply
in the product market. It is immediate that the industry output, and hence the
price, will depend on the cross-sectional distribution of firms.
Let µt denote the measure over the capital stocks and idiosyncratic shocks
for all the firms in the industry at time t. Let i(kt , zt ; xt , pt ) and y(kt , zt ; xt , pt )
denote, respectively, the optimal investment decision and output for the firm
with capital kt and idiosyncratic productivity zt facing log price pt and aggregate
productivity xt . Define to be any measurable set in the product space of k and
z, and let (µt , xt , xt+1 ) be the law of motion for the firm distribution µt . Then
(·, ·, ·) can be stated formally as
µt+1 (; xt+1 ) = T (, (kt , z t ); xt )µt (kt , z t ; xt ), (16)
where the operator T is defined as

T (, (kt , z t ); xt ) ≡ χ{(it +(1−δ)kt ,z t+1 )∈} Q z (d z t+1 | z t )Q x (d xt+1 | xt ). (17)
Although the exact condition is somewhat technical, the underlying intuition

is quite straightforward. Equation (16) says that the law of motion for the
individual states for the firms is obtained simply by combining their optimal
decision rules concerning capital accumulation, as formalized in (17). The total
industry output can be now written as

Yt ≡ y(kt , z t ; xt , pt )µt (d k, d z). (18)
D. Equilibrium
DEFINITION 1: A recursive competitive equilibrium is characterized by: (i) A log
industry output price p∗t ; (ii) an optimal investment rule i∗ (kt , zt ; xt , p∗t ), as well
as a value function v∗ (kt , zt ; xt , p∗t ) for each firm; and (iii) a law of motion of firm
distribution ∗ , such that:
r Optimality: i∗ (kt , zt ; xt , p∗ ) and v∗ (kt , zt ; xt , p∗ ) solve the value-maxi-
t t
mization problem (8) for each firm;
r Consistency: the aggregate output Yt is consistent with the production of all
firms in the industry, that is, (18) holds. The law of motion of firm distri-
bution ∗ is consistent with the optimal decisions of firms, that is, (16) and
(17) hold.
r Product market clearing

∗ −η
e pt = Y t . (19)
PROPOSITION 2: There exists a unique value function v(k, z, x, p) that satisfies (8)
and is continuous, increasing, and differentiable in k, z, x, and p, and concave
in k. In addition, a unique industry equilibrium exists.
Proof: See Appendix A.
II. Main Findings

In this section, I first calibrate the model in Section II.A. Section II.B
presents the main quantitative results and Section II.C investigates the eco-
nomic sources of the value premium within the model.
A. Calibration
Calibration of an economic model involves restricting some parameter values
exogenously and setting others to replicate a benchmark data set as a model
solution (e.g., Dawkins, Srinivasan, and Whalley (2001)). Once calibrated, the
model can be used to assess the effects of an unobservable change in exogenous
parameter values. The model solution provides predictions of the way in which
the economy is likely to respond to the change, while the pre-change solution
serves as the reference point.
Table I summarizes the key parameter values in the model. All model pa-
rameters are calibrated at the monthly frequency to be consistent with the
empirical literature. I break down all the parameters into three groups. The
first group includes parameters that can be restricted by prior empirical or
Table I
Benchmark Parameter Values
This table lists the benchmark parameter values used to solve and simulate the model. I break
all the parameters into three groups. Group I includes parameters whose values are restricted by
prior empirical or quantitative studies: capital share, α; depreciation, δ; persistence of aggregate
productivity, ρx ; conditional volatility of aggregate productivity, σx ; and inverse price elasticity of
demand, η. Group II includes parameters in the pricing kernel, β, γ0 , and γ1 , which are tied down
by matching the average Sharpe ratio and the mean and volatility of real interest rate. The final
group of parameters is calibrated with only limited guidance from prior empirical studies. I start
with a reasonable set of parameter values and conduct extensive sensitivity analysis in Tables III
and IV.
Group I Group II Group III
α δ ρx σx η β γ0 γ1 θ −/θ + θ+ ρz σz f
0.30 0.01 0.951/3 0.007/3 0.50 0.994 50 −1000 10 15 0.97 0.10 0.0365
quantitative studies: capital share α; depreciation δ; persistence ρx and con-

ditional volatility σx of aggregate productivity; and inverse price elasticity of
demand η. Because of the general consensus concerning their numerical values,
these parameters provide essentially no degrees of freedom for generating the
quantitative results.
The capital share α is set to be 30%, similar to that in Kydland and Prescott
(1982) and in Gomes (2001). The monthly rate of depreciation, δ, is set to be
0.01, which implies an annual rate of 12%, the empirical estimate of Cooper and
Haltiwanger (2000). The persistence of the aggregate productivity process, ρx ,
is set to be 0.951/3 = 0.983, and its conditional volatility, σx , 0.007/3 = 0.0023.
With the AR(1) specification for xt in (1), these monthly values correspond to
0.95 and 0.007 at the quarterly frequency, respectively, consistent with Cooley
and Prescott (1995). Finally, I follow Caballero and Pindyck (1996) and set the
inverse price elasticity of demand η to be 0.50.
The second group of parameters includes those in the pricing kernel: β, γ0 , and
γ1 . These parameters can be tied down by aggregate return moments implied
by the pricing kernel. The log pricing kernel in (4) and (5) implies that the
real interest rate Rft and the maximum Sharpe ratio St can be written as,
respectively,
1 −µm − 1 σm2
R f t = 1/Et [M t+1 ] = e 2 (20)
β
and
2 2
σt [M t+1 ] eσm (eσm − 1)
St = = , (21)
eσm /2
2
Et [M t+1 ]
where
µm ≡ [γ0 + γ1 (xt − x̄)](1 − ρx )(xt − x̄), (22)
σm ≡ σx [γ0 + γ1 (xt − x̄)]. (23)
I thus choose β, γ0 , and γ1 to match (i) the average Sharpe ratio; (ii) the average
real interest rate; and (iii) the volatility of real interest rate.11
This procedure yields β = 0.994, γ0 = 50, and γ1 = −1000, and they deliver an
average Sharpe ratio of 0.41, an average real interest rate of 2.2% per annum,
and an annual volatility of real interest rate of 2.9%. These moments are very
11
The long-run average aggregate productivity, x̄, determines the long-run average scale of the
economy, but does not affect stock returns directly. Equations (22) and (23) imply that returns are
not directly affected by the level of x̄, but by business cycle fluctuation, that is, xt − x̄. The degree
of this f luctuation is already pinned down by σx , the conditional volatility of the xt process. Thus x̄
is purely a scaling constant, and I set x̄ such that the long-term average capital stock is normalized
to be 1. This is done by solving the firm’s problem without uncertainty in closed form and then
imposing the steady-state condition. This implies that x̄ = −5.70. Other normalization schemes
yield quantitatively similar results. Normalizing x̄ is standard in the literature (e.g., Cooley and
Prescott (1995), Boldrin et al. (2001)).
close to those in the data reported by Campbell and Cochrane (1999) and by
Campbell, Lo, and MacKinlay (1997). As these parameters are pinned down
tightly by the aggregate return moments, they provide no degrees of freedom
in matching cross-sectional moments of returns, which are my focus here.
Importantly, a γ0 of 50 does not necessarily imply extreme risk aversion,
nor does a γ1 of −1,000. Because the pricing kernel is exogenously specified in
the model, the criterion of judging whether its parameters are representative
of reality should be whether the aggregate return moments implied by the
pricing kernel mimic those in the data. After all, I do not claim any credits in
explaining time series predictability; my contribution is to endogenize cross-
sectional predictability of returns, given time series predictability.
The calibration for the third group of parameters has only limited guidance
from prior studies and I have certain degrees of freedom in choosing their val-
ues. There are five parameters in this group: (i) the adjustment cost coefficient,
θ + ; (ii) the degree of asymmetry, θ −/θ + ; (iii) the conditional volatility of idiosyn-
cratic productivity, σz ; (iv) the persistence of idiosyncratic productivity, ρz ; and
(v) the fixed cost of production, f . I first choose their benchmark values by us-
ing available studies and by matching key moments in the data. I then conduct
extensive sensitivity analysis.
First, θ + can be interpreted as the adjustment time of the capital stock given
one unit change in marginal q (e.g., Shapiro (1986) and Hall (2001)). The first-
order condition with respect to investment for the value-maximization problem
says that θ + · (i/k) = q − 1, where q is the shadow price of additional unit of
capital. If q rises by one unit, the investment-capital ratio (i/k) will rise by
1/θ + . To cumulate to a unit increase, the f low must continue at this level for
θ + periods.
The empirical investment literature has reported a certain range for this ad-
justment time parameter. Whited (1992) reports this parameter to be between
0.5 and 2 in annual frequency, depending on different empirical specifications.
This range corresponds to an adjustment period lasting from 6 to 24 months.
Another example is Shapiro (1986), who finds the adjustment time to be about
eight calendar quarters or 24 months. I thus set the benchmark value of θ +
to be 15, which corresponds to the average empirical estimates, and conduct
sensitivity analysis by varying θ + from 5 to 25.
The empirical evidence on the degree of asymmetry, θ −/θ + , seems scarce.
Here I simply follow Hall (2001) and set its benchmark value to be 10 (Table III
contains comparative static experiments on this parameter).
To calibrate parameters ρz and σz , I follow Gomes (2001) and Gomes et al.
(2003) and restrict these two parameters using their implications on the degree
of dispersion in the cross-sectional distribution of firms. One direct measure
of the dispersion is the cross-sectional volatility of individual stock returns.
Moreover, since disinvestment in recessions is intimately linked to the value
premium, as argued in Section II.C below, it is important for the model to match
the average rate of disinvestment as well.
These goals are accomplished by setting ρz = 0.97 and σz = 0.10. These values
imply an average annual cross-sectional volatility of individual stock returns
of 28.6%, approximately the average of 25% reported by Campbell et al. (2001)

and 32% reported by Vuolteenaho (2001). Furthermore, the average annual rate
of disinvestment is 0.014, close to 0.02 in the data reported by Abel and Eberly
(2001).
The value of σz is also in line with the limited empirical evidence. Pástor
and Veronesi (2003) show that the average volatility of firm-level profitabil-
ity has risen from 10% per year in the early 1960s to about 45% in the late
1990s.12 The calibrated conditional volatility of firm-level productivity is 10%
per month, corresponding to 35% per year, which seems reasonable given the
range estimated by Pástor and Veronesi.
The unconditional volatility of idiosyncratic productivity is about 32 times
that of aggregate productivity. Such a high idiosyncratic shock is necessary to
generate a reasonable amount of dispersion in firm characteristics within the
model. However, even with such a high firm-level shock, firm value and in-
vestment rate are much more sensitive to changes in aggregate productivity xt
than to changes in idiosyncratic productivity zt .13 The reason is that xt affects
the stochastic discount factor, while zt does not; shocks at the firm-level are
mainly cash f low shocks that can be integrated out, while shocks at the aggre-
gate level consist primarily of discount rate shocks, consistent with Vuolteenaho
(2001).
Finally, I am left with the fixed cost of production, f . Since f deducts the
firm’s profit given in (7), it has a direct impact on the market value of the firm.
I thus calibrate f to be 0.0365 such that the average book-to-market ratio in the
economy is 0.54, which matches approximately that in the data, 0.67, reported
by Pontiff and Schall (1999).
Table II reports the set of key moments generated using the benchmark pa-
rameters. I simulate 100 artificial panels each with 5,000 firms and 900 months.
I then compute the return and quantity moments for each sample and report
the cross-sample averages in Table II. The corresponding moments in the data
are also reported for comparison.
Table II suggests that the model does a reasonable job of matching these
return and quantity moments. Importantly, the fit seems reasonable not only
for the moments that serve as immediate targets of calibration, but also for
other moments. The mean and volatility of industry return are comparable
to those computed using the industry portfolios of Fama and French (1997).
The volatility of aggregate book-to-market ratio is 0.24, close to that of 0.23
reported by Pontiff and Schall (1999). The average rate of investment is 0.135
in the model, close to 0.15 in the data reported by Abel and Eberly (2001). In
sum, the calibrated parameter values seem reasonably representative of the
reality.
12
It is a topical area to explain this upward trend in firm-level profitability associated with the
trend in idiosyncratic volatility documented in Campbell et al. (2001). But this is outside the scope
of this paper.
13
These results were reported in a previous version of the paper, but not in the current version
to save space. They are available upon request.
Table II
Key Moments under the Benchmark Parametrization
This table reports a set of key moments generated under the benchmark parameters reported
in Table I. The data source for the average Sharpe ratio is the postwar sample of Campbell and
Cochrane (1999). The moments for the real interest rate are from Campbell et al. (1997). The data
moments for the industry returns are computed using the 5-, 10-, 30-, and 48-industry portfolios in
Fama and French (1997), available from Kenneth French’s web site. The numbers of the average
volatility of individual stock return in the data are from Campbell et al. (2001) and Vuolteenaho
(2001). The data source for the moments of book-to-market is Pontiff and Schall (1999), and the
annual average rates of investment and disinvestment are from Abel and Eberly (2001).
Moments Model Data
Average annual Sharpe ratio 0.41 0.43

Average annual real interest rate 0.022 0.018
Annual volatility of real interest rate 0.029 0.030
Average annual value-weighted industry return 0.13 0.12–0.14
Annual volatility of value-weighted industry return 0.27 0.23–0.28
Average volatility of individual stock return 0.286 0.25–0.32
Average industry book-to-market ratio 0.54 0.67
Volatility of industry book-to-market ratio 0.24 0.23
Annual average rate of investment 0.135 0.15
Annual average rate of disinvestment 0.014 0.02
B. Empirical Predictions
I now investigate the empirical predictions of the model concerning the cross
section of returns. I show that (i) the benchmark model with asymmetry and a
countercyclical price of risk is capable of generating a value premium similar to
that in the data. And (ii) without these two features, an alternative parameter
set does not exist that can produce the correct magnitude of the value premium.
Therefore, at least in the model, asymmetry and countercyclical price of risk
are necessary driving forces of the value premium.
Table III reports summary statistics, including means, volatilities, and un-
conditional betas for portfolio HML and for 10 portfolios sorted on book-to-
market, using both the historical data and 10 artificial data simulated in the
model.14 The book value of a firm in the model is identified as its capital stock,
and the market value is defined as the ex dividend stock price, as in footnote
10. I follow Fama and French (1992, 1993) in constructing HML and 10 book-
to-market portfolios for each simulated panel. I repeat the entire simulation
100 times and report the cross-simulation averages of the summary statistics
in Table III. From Panel A, the benchmark model is able to generate a positive
relation between book-to-market and average returns. The benchmark model
generates a reliable value premium, measured as the average HML return,
which is quantitatively similar to that in the data.
14
The historical data on 10 book-to-market portfolios are those used in Davis, Fama, and French
(2000) and are available from Kenneth French’s web site. The sample ranges from July 1927 to
December 2001.
Table III
Properties of Portfolios Sorted on Book-to-Market
This table reports summary statistics for HML and 10 book-to-market portfolios, including mean,
m, volatility, σ , and market beta, β. Both the mean and the volatility are annualized. The average
HML return (the value premium) is in annualized percent. Panel A reports results from historical
data and benchmark model with asymmetry and countercyclical price of risk (θ −/θ + = 10 and γ1 =
−1000). Panel B reports results from two comparative static experiments. Model 1 has symmetric
adjustment cost and constant price of risk (θ −/θ + = 1 and γ1 = 0), and Model 2 has asymmetry
and constant price of risk (θ −/θ + = 10 and γ1 = 0). All the model moments are averaged across
100 artificial samples. All returns are simple returns.
Panel A: Data and Benchmark Panel B: Comparative Statics
Data Benchmark Model 1 Model 2
m β σ m β σ m β σ m β σ
HML 4.68 0.14 0.12 4.87 0.43 0.12 2.19 0.09 0.04 2.54 0.11 0.04
Low 0.11 1.01 0.20 0.09 0.85 0.23 0.08 0.95 0.30 0.08 0.94 0.30
2 0.12 0.98 0.19 0.10 0.92 0.24 0.09 0.97 0.31 0.09 0.97 0.31
3 0.12 0.95 0.19 0.10 0.95 0.25 0.09 0.99 0.31 0.09 0.98 0.31
4 0.11 1.06 0.21 0.11 0.98 0.26 0.09 1.00 0.32 0.10 0.99 0.31
5 0.13 0.98 0.20 0.11 1.01 0.27 0.10 1.00 0.32 0.10 1.00 0.32
6 0.13 1.07 0.22 0.12 1.04 0.28 0.10 1.01 0.32 0.10 1.01 0.32
7 0.14 1.13 0.24 0.12 1.08 0.28 0.10 1.02 0.32 0.10 1.02 0.32
8 0.15 1.14 0.24 0.12 1.12 0.30 0.10 1.03 0.33 0.11 1.04 0.33
9 0.17 1.31 0.29 0.13 1.18 0.31 0.11 1.04 0.33 0.11 1.05 0.33
High 0.17 1.42 0.33 0.15 1.36 0.36 0.11 1.07 0.34 0.12 1.08 0.34
To evaluate the role of asymmetry and the countercyclical price of risk, I con-
duct comparative static experiments in Panel B of Table III by varying two key
parameters governing the degree of asymmetry, θ −/θ + , and the time-variation
of the log pricing kernel, γ1 . Two cases are considered: Model 1 has symmet-
ric adjustment cost and the constant price of risk (θ −/θ + = 1 and γ1 = 0) and
Model 2 has asymmetry and constant price of risk (θ −/θ + = 10 and γ1 = 0). All
other parameters remain the same as in the benchmark model.
Panel B of Table III shows that, without asymmetry or time-varying price
of risk, Model 1 displays a small amount of the value premium. Introducing
asymmetry in Model 2 increases the amount somewhat, but it is still lower than
that in the benchmark model. In short, asymmetry and the time-varying price
of risk seem indispensable for generating the value premium in the benchmark
model.
However, the importance of these features established in Table III is condi-
tional on the benchmark calibration of Model 1. It is possible that even without
these two features, an alternative parameter set may exist in Model 1 that will
produce the correct magnitude for the value premium. I thus conduct exten-
sive sensitivity analysis on Model 1 by varying its parameter values from the
benchmark calibration.
Panels A–H of Table IV report the results from the following eight compar-
ative static experiments on Model 1: Low Volatility (σz = 0.08, Panel A); High
Table IV
The Performance of Model 1 (θ −/θ + = 1 and γ1 = 0) under Alternative
Parameter Values
This table reports summary statistics for HML and 10 book-to-market portfolios, including annu-
alized mean, m, and volatility, σ , and market beta, β, generated from Model 1 without asymmetry
and countercyclical price of risk. The average HML returns are in annualized percent. Nine alter-
native parameter values are considered: Low Volatility (σz = 0.08); High Volatility (σz = 0.12); Fast
Adjustment (θ + = 5); Slow Adjustment (θ + = 25); Low Fixed Cost (f = 0.0345); High Fixed Cost
( f = 0.0385); Low Persistence (ρz = 0.95); High Persistence (ρz = 0.98); and High Volatility, Slow
Adjustment, High Fixed Cost, and High Persistence (Panel I). All moments are averaged across
100 artificial samples. All returns are simple returns.
Panel A. Panel B. Panel C. Panel D.

Low Volatility High Volatility Fast Adjustment Slow Adjustment
m β σ m β σ m β σ m β σ
HML 1.78 0.07 0.03 2.28 0.10 0.04 1.57 0.07 0.04 2.31 0.08 0.03
Low 0.08 0.95 0.30 0.08 0.94 0.29 0.09 0.96 0.30 0.07 0.95 0.29
2 0.09 0.98 0.31 0.09 0.97 0.30 0.10 0.98 0.31 0.08 0.98 0.30
3 0.09 0.99 0.31 0.10 0.99 0.31 0.10 0.99 0.31 0.09 0.99 0.31
4 0.09 1.00 0.31 0.10 1.00 0.31 0.10 0.99 0.32 0.09 1.00 0.31
5 0.10 1.00 0.31 0.10 1.01 0.31 0.10 1.00 0.32 0.09 1.00 0.31
6 0.10 1.01 0.32 0.10 1.02 0.32 0.10 1.01 0.32 0.10 1.01 0.32
7 0.10 1.02 0.32 0.11 1.02 0.32 0.11 1.02 0.32 0.10 1.02 0.32
8 0.10 1.02 0.32 0.11 1.04 0.32 0.11 1.02 0.33 0.10 1.03 0.32
9 0.10 1.03 0.32 0.11 1.05 0.33 0.11 1.04 0.33 0.11 1.04 0.32
High 0.11 1.05 0.33 0.12 1.08 0.34 0.12 1.07 0.34 0.11 1.06 0.33
Panel E. Panel F. Panel G. Panel H. Panel I.

Low Fixed Cost High Fixed Cost Low Persistence High Persistence
m β σ m β σ m β σ m β σ m β σ
HML 1.89 0.07 0.03 2.34 0.12 0.05 1.88 0.07 0.03 2.63 0.12 0.05 3.13 0.12 0.05
Low 0.08 0.95 0.30 0.09 0.93 0.30 0.09 0.95 0.30 0.07 0.94 0.29 0.05 0.93 0.28
2 0.09 0.98 0.31 0.09 0.97 0.31 0.09 0.98 0.30 0.08 0.97 0.30 0.07 0.97 0.29
3 0.10 0.99 0.31 0.10 0.98 0.31 0.10 0.99 0.31 0.09 0.98 0.31 0.07 0.98 0.30
4 0.10 1.00 0.31 0.10 0.99 0.32 0.10 1.00 0.31 0.09 0.99 0.31 0.08 1.00 0.30
5 0.10 1.00 0.31 0.10 1.00 0.32 0.10 1.00 0.31 0.09 1.00 0.31 0.08 1.01 0.31
6 0.10 1.01 0.32 0.11 1.01 0.32 0.10 1.01 0.31 0.09 1.01 0.32 0.08 1.02 0.31
7 0.10 1.02 0.32 0.11 1.02 0.33 0.10 1.02 0.32 0.10 1.03 0.32 0.09 1.03 0.31
8 0.11 1.02 0.32 0.11 1.04 0.33 0.11 1.02 0.32 0.10 1.04 0.32 0.09 1.04 0.32
9 0.11 1.03 0.32 0.11 1.05 0.33 0.11 1.03 0.32 0.10 1.06 0.33 0.10 1.06 0.32
High 0.12 1.05 0.33 0.12 1.09 0.35 0.11 1.05 0.33 0.11 1.11 0.35 0.11 1.10 0.33
Volatility (σz = 0.12, Panel B); Fast Adjustment (θ + = 5, Panel C); Slow Adjust-
ment (θ + = 25, Panel D); Low Fixed Cost (f = 0.0345, Panel E); High Fixed Cost
(f = 0.0385, Panel F); Low Persistence (ρz = 0.95, Panel G); and High Persis-
tence (ρz = 0.98, Panel H). These experiments cover a wide range of empirically
plausible parameter values. A conditional volatility of 12% per month for the
idiosyncratic productivity corresponds to 42% per year, close to the upper bound
of 45% estimated by Pástor and Veronesi (2003). As argued in Section II.A, the
two alternative values of θ + cover the range of its empirical estimates. The two
values of fixed cost of production imply a wide range of industry book-to-market,
from 0.29 to 9.58. Finally, a persistence level of 0.98 for the idiosyncratic pro-
ductivity is close to that of the aggregate productivity, and is likely to be an
upper bound.15
Importantly, Table IV shows that the amount of value premium generated
from the eight alternative parameter sets of Model 1 is uniformly much lower
than that in the data and that in the benchmark model. The table also indi-
cates that the magnitude of the value premium increases with the persistence
and conditional volatility of idiosyncratic productivity, the adjustment time pa-
rameter, and the fixed cost of production.16 A natural question is then whether
Model 1 can generate the correct magnitude of the value premium by combin-
ing all the extreme parameter values used in Panels B, D, F, and H. Panel I in
Table IV reports that this is not true. The value premium generated from this
parameter set is still lower than that in the data by 1.5% per annum.
In sum, the simulation results indicate that (i) an alternative parameter
set does not exist that will produce the correct magnitude for the value pre-
mium in Model 1 without asymmetry and the countercyclical price of risk. And
(ii) once these two ingredients are incorporated, the benchmark model is able
to generate a value premium consistent with the data. I conclude that, at least
in the model, asymmetry and the countercyclical price of risk are necessary
driving forces of the value premium.
C. Causality
I now focus on the causal relation of asymmetry and the countercyclical price
of risk to the value premium. I first demonstrate that productivity difference
is what determines the value or growth characteristics of firms to begin with.
I then investigate how productivity difference transforms to difference in risk
and expected return through optimal investment. Finally, I examine how the
structural link between productivity and expected return is affected by the deep
parameters governing the degree of asymmetry and time-variation in the price
of risk.
C.1. Profitability
Following Fama and French (1995), I examine the average profitabilities of
value and growth strategies for 11 years around portfolio formation and in the
15
Fama and French (2000) estimate the annual rate of mean reversion of firm-level profitability
(including both aggregate and idiosyncratic components) to be 0.38, implying a monthly persistence
level lower than 0.983, which is the persistence of the aggregate productivity.
16
The prediction that the value premium increases with the fixed cost of production is consistent
with Carlson et al. (2004).
Panel A: Return on Equity (ROE) Panel B: Time-Series of ROE

0.4 0.5
0.3 Growth 0.4
0.3
0.2
Profitability
Profitability
0.2
0.1
0.1 Growth
0
0
Value
−0.1
Value −0.1
−0.2 −0.2
−6 −4 −2 0 2 4 6 0 10 20 30 40 50 60 70 80
Formation Year Time Series
Figure 2. The value factor in profitability (ROE). Following Fama and French (1995), I mea-
sure profitability by return on equity, that is [kt + dt ]/kt−1 , where kt denotes the book value of
equity and dt is the dividend payout. Thus profitability equals the ratio of common equity income for
the fiscal year ending in calender year t and the book value of equity for year t − 1. The profitability
of a portfolio is defined as the sum of [kjt + djt ] for all firms j in the portfolio divided by the sum
of kjt−1 ; thus it is the return on book equity by merging all firms in the portfolio. For each portfolio
formation year t, the ratios of [kt+i + dt+i ]/kt+i−1 are calculated for year t + i, where i = −5, . . . , 5.
The ratio for year t + i is then averaged across portfolio formation years. Panel A shows the
11-year evolution of profitability for value and growth portfolios. Time 0 on the horizontal axis
is the portfolio formation year. Panel B shows the time series of profitability for value and growth
portfolios. Value portfolio contains firms in the top 30% of the book-to-market ratios and growth
portfolio contains firms in the bottom 30% of the book-to-market ratios. The figure is generated
under the benchmark model, and varying θ −/θ + and γ1 yields similar results.
time series for each simulated panel with 5,000 firms and 900 months. I then
repeat the same analysis on 100 simulated panels and report the cross-sample
average results in Figure 2.17
Figure 2 demonstrates that, consistent with Fama and French (1995), book-
to-market is associated with persistent differences in profitability. In the model,
growth firms are on average more profitable than value firms for 5 years be-
fore and 5 years after portfolio formation. The profitability of growth firms
improves prior to portfolio formation and deteriorates thereafter, and the oppo-
site is true for value firms. This pattern is driven by the mean-reverting behav-
ior of the idiosyncratic productivity, zt . The difference in profitability between
value and growth is also confirmed in Panel B, where profitability is examined
chronologically. In sum, idiosyncratic productivity corresponding empirically
to firm-level profitability is what determines value or growth characteristic
for a specific firm, given that it is the only source of firm heterogeneity in the
model.
17
The figure is generated under the benchmark model. The results from varying the two param-
eters θ −/θ + and γ1 are qualitatively similar, and are hence omitted.
C.2. Corporate Investment

A standard result from the neoclassical investment literature (e.g., Abel
(1983), Abel and Eberly (1994)) is that the optimal investment rate, it /kt , in-
creases with productivity. In my framework, the relative productivity pattern
in Figure 2 has a direct impact on the optimal investment of value and growth
firms across business cycles. Since growth firms are more productive than value
firms, they tend to invest more and grow faster than value firms. This is espe-
cially the case in good times when the aggregate productivity is high. In bad
times, since value firms are burdened with more unproductive capital stocks,
they tend to cut more capital than growth firms.
To verify these predictions in the model, I plot in Figure 3 the amount of ad-
justment cost h(it , kt ) defined in (10) as a function of the investment rate it /kt
for value and growth firms in bad times (Panel A) and in good times (Panel B).
Good times are defined as times when aggregate productivity, xt , is more than
one unconditional standard deviation σx / 1 − ρx2 above its unconditional mean
x, and bad times are defined as times when xt is more than one standard de-
viation below its unconditional mean. Within each simulated sample, I aver-
age the adjustment costs and the investment rates of value and growth firms
across all the good or bad times. I then repeat the simulation 100 times and
Panel A: Bad Times Panel B: Good Times

−3
x 10
1.5
0.01
Value 0.009
0.008
Adjustment Cost
1 0.007
Adjustment Cost
Growth
0.006 Value
0.005
0.004
0.5
0.003
0.002
0.001 Growth
0 0
−6 −4 −2 0 2 4 6 8 10 0.005 0.01 0.015 0.02 0.025
−3
i/k x 10 i/k
Figure 3. The value factor in corporate investment. This figure illustrates the value factor
in corporate investment under the benchmark model. Panel A plots the adjustment cost, h(it , kt ) =
θt it 2
2 ( kt ) kt , as a function of the investment rate, it /kt , in bad times for value firms (the “+”s) and
growth firms (the “o”s). Panel B presents the same plot in good times. Good times are defined
as times
when the aggregate productivity, xt , is more than one unconditional standard deviation,
σx / 1 − ρx2 , above its unconditional mean, x. Bad times are defined as times when xt is more than
one standard deviation below its long-run level. Within each simulated sample, the investment
rates and adjustment costs are averaged across all the good or the bad times for value and growth
firms. I then repeat the simulation 100 times and plot the cross-simulation average adjustment
costs against the cross-simulation average investment rates. The figure is generated within the
benchmark model, and varying θ −/θ + and γ1 yields similar results.
plot the cross-simulation average results in Figure 3.18 Figure 3 demonstrates

that:
HYPOTHESIS 1: Value firms disinvest more and incur higher adjustment costs
than growth firms in bad times, and growth firms invest more and incur higher
adjustment costs than value firms in good times.
The endogenous link between productivity and investment is the point where
my model departs from that of Gomes et al. (2003). Although their model is
able to generate the relative profitability pattern between value and growth,
it cannot generate the link between profitability and capital investment. They
assume, for the sake of analytical tractability, that all firms in the economy
have equal growth options, that is, capital investment is ex ante independent of
current productivity. By relaxing the equal-growth restriction, my model allows
firms to condition their investments optimally on their current productivity, as
in a neoclassical, dynamic world.
C.3. Risk as Inflexibility

How does the difference in productivity translate into differences in beta and
expected return between value and growth strategies? In production economies
with endogenous dividends, the risk of a firm is inversely related to its flexibility
in utilizing its capital investment to mitigate the effects of exogenous shocks so
as to generate a relatively smooth dividend stream. The more f lexibility a firm
has in this regard, the less risky it is.
This f lexibility is responsible for why it is more difficult to generate a high
equity premium in a production economy than in an endowment economy (e.g.,
Rouwenhorst (1995), Jermann (1998), Boldrin, Christiano, and Fisher (2001)).
After a positive productivity shock in an endowment economy, all the addi-
tional cash f lows will transform into dividends unit-by-unit. In a production
economy with the possibility of capital adjustment, however, the firm will in-
vest to increase its capital stock because productivity is persistent. Part of
the incremental cash f low will be allocated as investment, and the resulting
dividend stream will not covary as much with business cycles as it would
in an endowment economy. As a result, the return of the firm will be less
risky.
Capital adjustment cost, by definition, is the offsetting force of the dividend
smoothing mechanism. The higher the adjustment cost the firm faces, the less
f lexibility it has in adjusting capital, and the riskier its return will be. The
endowment economy is in effect the limiting case of the production economy,
when the adjustment cost is infinite and the channel of capital investment is
completely shut down.
18
The figure is generated within the benchmark model. The results from varying θ −/θ + and γ1
are qualitatively similar and are hence omitted.
Panel A: Expected Value Premium Panel B: The Value Spread

18
0.08
16
0.07
Benchmark 14 Benchmark
Expected Excess Return
0.06
Book−to−Market
12
0.05
10
Model 2 Model 2
0.04
8
0.03
6
Model 1
0.02 4
0.01 2
Model 1
0 0
−5.73 −5.72 −5.71 −5.7 −5.69 −5.68 −5.73 −5.72 −5.71 −5.7 −5.69 −5.68
x x
Figure 4. Time-varying spreads in expected excess return and in book-to-market be-

tween low-productivity (value) and high-productivity (growth) firms. This figure plots
the spread in expected excess returns (Panel A) and the spread in book-to-market (Panel B) be-
tween firms with low idiosyncratic productivity and firms with high idiosyncratic productivity as
functions of aggregate productivity, x. As is evident from Figure 2, sorting on firm-level productivity,
zt , in the model is equivalent to sorting on book-to-market. In effect, Panel A plots the time-varying
expected value premium, and Panel B plots the time-varying spread in book-to-market (which
Cohen et al. (2003) call the value spread) across business cycles. Three versions of the model are
considered. The solid lines are for the benchmark model with asymmetry and countercyclical price
of risk (θ −/θ + = 10 and γ1 = −1000). The broken lines are for Model 1 with symmetric adjustment
cost and a constant price of risk (θ −/θ + = 1 and γ1 = 0). Finally, the dotted lines are for Model 2
with asymmetry and constant price of risk (θ −/θ + = 10 and γ1 = 0). The figure is generated with
firm-level capital k and log output price p at their long-run average levels. Other values of k and p
yield similar results.
How does the firm-level productivity affect risk and expected return? Panel A
of Figure 4 plots the spread in expected excess return between firms with
low and high idiosyncratic productivity, zt , against the aggregate productiv-
ity, xt . Panel B does the same for the spread in book-to-market, which Co-
hen et al. (2003) call the value spread.19 As is evident from Figure 2, sort-
ing on firm-level productivity zt in the model is equivalent to sorting on
book-to-market. Effectively, Panel A plots the time-varying expected value
premium and Panel B plots the time-varying value spread across business
cycles.
The broken lines in Figure 4 show that without asymmetry or a counter-
cyclical price of risk (Model 1), both the expected value premium and the
value spread are low. The dotted lines indicate that introducing asymme-
try (Model 2) has a small effect on the value spread, but it almost doubles
the expected value premium in bad times with low values of xt . Finally, the
19
In the figure, both firm-level capital stock k and log output price p are kept at their long-run
average levels. Other values of k and p yield similar results, which are available from the author
upon request.
solid lines suggest that the two spreads rise dramatically once both asymme-
try and the time-varying price of risk are incorporated into the benchmark
model.
These results are fairly intuitive. Consider Model 1 first. When times are
bad, an average firm will invest at a lower rate than the long-run average rate.
Value firms with low firm-level productivity will start to disinvest. Without
asymmetry, value firms have enough f lexibility to disinvest, rendering a low
expected value premium. With asymmetry in Model 2, as soon as value firms
start to disinvest in bad times, they immediately face steeper adjustment costs.
This deprives them of f lexibility in smoothing dividends, which now have to
covary more with economic downturns. As a result, value is riskier than growth
in bad times.
Next, relative to the constant price of risk, the time-varying price of risk
intensifies the incentives for value firms to disinvest in bad times. Accordingly,
value firms face even less f lexibility, giving rise to much higher value premium
and value spread in bad times.
What drives this effect? Consider the pricing kernel, Mt+1 , that firms use
to determine the expected continuation value, Et [Mt+1 vt+1 ], the last term in
(8). Figure 5 plots the key moments of Mt+1 , including the mean, volatil-
ity, and the Sharpe ratio, against the aggregate productivity xt , for both
cases with γ1 = 0 and γ1 = −1000. Panel A shows that γ1 = −1000 gen-
erates a reasonable amount of time-variation in the price of risk, consis-
tent with Lettau and Ludvigson (2003), while the price of risk is con-
stant with γ1 = 0. Moreover, Panel B of Figure 5 indicates that the kernel
in the benchmark model is also more volatile in bad times than in good
times.
Importantly, when the price of risk is time-varying, Panel C of Figure 5 shows
that the discount factor, Mt+1 , will be lower on average than that with a con-
stant price of risk in bad times. It follows that the expected continuation value,
Panel A:
Panel B: σ t [Mt+1 ] Panel C: Et [Mt+1 ]
σ t [Mt+1 ]/Et [Mt+1 ]
0.2 0.2 1.04
0.18 0.18 1.03
0.16 0.16
1.02
0.14 0.14
σt[Mt+1]/Et[Mt+1]
1.01
]
σt[Mt+1]
0.12 0.12
t+1
1
E [M
t
0.1 0.1
0.99
0.08 0.08
0.98
0.06 0.06
0.04 0.04 0.97
0.02 0.02 0.96

−5.74 −5.73 −5.72 −5.71 −5.7 −5.69 −5.68 −5.67 −5.74 −5.73 −5.72 −5.71 −5.7 −5.69 −5.68 −5.67 −5.74 −5.73 −5.72 −5.71 −5.7 −5.69 −5.68 −5.67
x x x
Figure 5. Properties of the pricing kernel M t+1 . This figure plots the key moments of the
pricing kernel, Mt+1 , defined in (4) and (5), including the conditional Sharpe ratio σt [Mt+1 ]/Et [Mt+1 ]
(Panel A), the conditional volatility σt [Mt+1 ] (Panel B), and the conditional mean Et [Mt+1 ] (Panel C),
all at monthly frequency, as functions of the aggregate productivity xt . The solid lines are for the
case with γ1 = −1000 (time-varying price of risk) and the broken lines are for the case with γ1 = 0
(constant price or risk).
Et [Mt+1 vt+1 ], will be lower.20 As future prospects become gloomier, value firms
will want to scrap even more capital than in the case with constant price of risk.
Since asymmetry creates high costs that prevent value firms from disinvesting,
they are in effect stuck with more unproductive capital stocks in bad times. In
short, the discount rate mechanism interacts with and propagates the effects
of asymmetry, giving rise to much higher expected value premium and value
spread in bad times.
The second effect of time-varying price of risk occurs through the pricing rela-
tion (12), which states that the expected value premium equals the risk spread
between value and growth times the price of risk. The benchmark model gets
an extra boost in generating the value premium because asymmetry implies
that value is riskier than growth in bad times; and the price of risk is high
precisely during these times. To summarize:
HYPOTHESIS 2: The expected value premium and the value spread are counter-
cyclical.
HYPOTHESIS 3: The cross-industry correlation between the degree of asymmetry

and the expected value premium is positive.
These predictions seem intriguingly consistent with the limited available
evidence. Cohen et al. (2003) document that “the expected return on value-
minus-growth strategies is atypically high at times when their spread in book-
to-market ratios is wide” (p. 609). However, they do not test whether these times
are indeed economic recessions, as predicted by the model.
C.4. Discussion
The inf lexibility mechanism is the most crucial innovation of my work rela-
tive to Gomes et al. (2003, hereafter GKZ). The driving force of the value pre-
mium in their model is that growth firms have shorter cash-f low durations than
value firms. This pattern is intimately linked to GKZ’s equal-growth assump-
tion. Since more profitable growth firms cannot invest more or grow faster, by
construction, they have to pay out more dividends than value firms. However,
in the data, growth firms are less likely to pay out dividends: Growth firms have
longer equity durations than value firms (see footnote 5). The equal-growth as-
sumption also seems very undesirable given the evidence in Fama and French
(1995) that growth firms invest more and grow faster than value firms. Finally,
since book-to-market corresponds naturally to the inverse of Tobin’s Q, that
20
Strictly speaking, Et [Mt+1 vt+1 ] = Et [Mt+1 ]Et [vt+1 ] + Covt [Mt+1 , vt+1 ]. One can also write the co-
variance term further as σt [Mt+1 ]σt [vt+1 ]ρt [Mt+1 , vt+1 ], where ρ(·, ·) denotes correlation. Now when
Mt+1 goes down on average, the first term of Et [Mt+1 vt+1 ] decreases. As for the second term, note
that Panel B of Figure 5 shows that, with a countercyclical price of risk, σt [Mt+1 ] is higher in bad
times than its counterpart with a constant price of risk. But this change only reinforces the effect
of the first term, since the correlation term is negative. To see this, suppose xt+1 goes up as a result
of a positive shock. Then vt+1 goes up naturally, but Mt+1 will go down, according to (4).
book-to-market is not related to growth does not accord well either with the
common practice of using Tobin’s Q as a proxy for growth.21
Relaxing the equal-growth assumption within the confines of the GKZ frame-
work does not seem easy. In their model, growth options are always riskier than
assets in place. If growth firms indeed have high growth options, then they will
have to be riskier and earn higher average returns than value firms. In effect,
GKZ get the sign of the expected value premium right, but only at the expense
of breaking up the link between book-to-market (or Tobin’s Q) to growth. Once
the link is restored, the value effect will quickly disappear.
I demonstrate that all the seemingly puzzling pieces fit together naturally
once the full-f ledged, neoclassical model is worked out. By lifting the equal-
growth restriction, my model allows firms to condition investment decisions
optimally on their current productivity. Growth firms in my model indeed in-
vest more and grow faster than value firms. A new mechanism for the value
premium arises: Asymmetry and the time-varying price of risk cause value to
be riskier than growth, especially in bad times when the price of risk is high.
It is worthwhile to point out that my model manages to explain more empirical
regularities than GKZ’s, by going back to the neoclassical world with less re-
strictive assumptions. I have incurred higher computational costs as a result,
but it is time to trade analytical elegance for economic relevance.
III. Further Implications

The model also yields an array of other testable hypotheses. Some have been
confirmed in the literature, lending further credibility to the model. Others are
new and can provide fresh directions for future empirical research.
A. Style Timing
The model can serve as a well-specified laboratory to investigate the pre-
dictability of the value-minus-growth return, commonly known among practi-
tioners as “style-timing.” I perform predictive regressions of the HML return on
the value spread (measured as the log book-to-market of portfolio High minus
that of portfolio Low), the earnings growth spread (measured as the log return
on book equity of portfolio Low minus that of portfolio High), the demeaned
aggregate productivity, and the median book-to-market in the industry. I also
calculate the correlation matrix of the HML return and the regressors. The anal-
ysis is conducted on each simulated panel with 5,000 firms and 900 months; the
sample size is roughly comparable to that typically used in empirical studies.
I then repeat the simulation and estimation 100 times and report the cross-
simulation averages in Table V.
From Panel A, the value spread is the most powerful predictor of future
value premium, especially in annual frequency. The earnings growth spread has
21
See, for example, Barclay, Smith, and Watts (1995), Lang, Ofek, and Stulz (1996), and Barclay,
Smith, and Morellec (2003).
Table V
Predictability of the Value-Minus-Growth Return
This table illustrates the predictability of value-minus-growth in the model. Panel A reports the results from predictive regressions for the HML return
on (separately and jointly) the value spread (VP, measured as the log book-to-market of portfolio High minus that of portfolio Low), the earnings growth
spread (EG, measured as the log return on book equity of portfolio Low minus that of portfolio High), the deviation of the aggregate productivity from its
long-term average (x − x̄), and the median book-to-market in the industry (k/ve ), both in monthly and annual frequencies. Portfolios High, Low, and HML
are constructed with the two-by-three sort of Fama and French (1993). The t-statistics are reported in parentheses, and are adjusted for heteroscedasticity
and autocorrelation up to 12 lags. All the intercepts and adjusted R2 ’s are in percent. Panel B reports the correlation matrix of HML and all the regressors,
both in the monthly and annual frequencies. The analysis is conducted on each simulated panel with 5,000 firms and 900 months; the sample size is roughly
comparable to that typically used in empirical studies. I then repeat the simulation and estimation 100 times and report the cross-simulation averages.
Panel A: Predictive Regressions

Monthly Annual
The Value Premium

Intercept VP EG x − x̄ k/ve Adj-R 2
Intercept VP EG x − x̄ k/ve Adj-R2
−0.25 0.01 0.60 −4.19 0.13 8.84

(−0.85) (1.66) (−2.04) (3.77)
0.19 0.04 0.16 −2.73 0.20 6.42
(1.41) (0.89) (−1.30) (2.95)
−0.29 0.01 0.02 0.71 −4.95 0.11 0.06 11.04
(−0.97) (1.63) (0.51) (−1.97) (1.75) (0.65)
0.30 −0.18 0.47 3.58 −2.16 9.45
(3.14) (−1.84) (3.67) (−2.79)
−0.36 0.01 −0.00 0.63 −7.58 0.16 −0.02 6.38
(−0.50) (1.33) (−0.20) (−1.24) (2.71) (−0.62)
Panel B: Correlation Matrix
Monthly Annual
HML VP EG x − x̄ k/ve HML VP EG x − x̄ k/ve
HML 1 0.08 0.03 −0.07 0.05 HML 1 0.28 0.25 −0.25 0.19
VP 1 0.25 −0.86 0.73 VP 1 0.78 −0.93 0.78
EG 1 −0.35 0.22 EG 1 −0.66 0.31
x − x̄ 1 −0.90 x − x̄ 1 −0.90
k/ve 1 k/ve 1
91
predictive power as well, but it seems weaker than that of the value spread. The
correlation matrix in Panel B also confirms these observations. These results
are consistent with Asness et al. (2000) and with Cohen et al. (2003).
The model makes a further, untested prediction. Panel A of Table V reports
that the slope coefficient of regressing the annual HML return on the demeaned
aggregate productivity is negative and significant. Panel B reports that the
correlation between the two variables is −0.25. The simulations thus predict
that the expected value premium is countercyclical.
B. Predictability of the Industry Cost of Capital

The model also has some implications for the predictability of the industry
cost of capital. Table VI reports a predictive regression of the value-weighted
industry return on the industry book-to-market and the value spread. All
model statistics are obtained by averaging results from 100 samples, each of
which has 840 monthly periods. The sample size is comparable to that used
in Pontiff and Schall (1999). Consistent with Kothari and Shanken (1997) and
Pontiff and Schall, who use the market portfolio, Panel A shows that the in-
dustry book-to-market is a significant, positive predictor of the one-period-
ahead aggregate cost of capital in the model, both at monthly and annual
frequencies.
The intuition is simple. Figure 4 indicates that firm-level expected excess
return and book-to-market both decrease with aggregate productivity, xt , which
is the main force driving the time-series fluctuation at the industry level. So
regressing the ex post realized industry return on industry book-to-market will
yield a positive slope. The same logic also explains the pattern in Panel B of
Table VI that the value spread is a positive predictor of future industry returns,
since both the value spread and the expected excess return decrease with xt .
The predictive power associated with the value spread seems even higher than
that of book-to-market. In sum:
HYPOTHESIS 4: The industry cost of capital increases with the industry book-to-
market and with the value spread within the industry.
C. Equilibrium Effect
The industry equilibrium framework allows the time-varying cross-sectional
distribution of firms, µt , to affect risk and expected return as well. The output
price, pt , depends on µt , and pt enters the value function (8) as a separate state
variable. Since the output price affects firms’ cash f lows in the same way as zt
does, the model predicts a negative correlation between the output price and
risk and expected return at the industry level.
Furthermore, some seemingly idiosyncratic risk variables, for example, the
average stock return variance, can affect firm-level systematic risk and ex-
pected returns because they can be used in predicting the future evolution of the
output price. This holds even after one controls for aggregate productivity, xt ,
Table VI
Predictability of the Industry Cost of Capital
Panel A reports the predictive regressions of the end-of-the-period value-weighted industry returns
on the beginning-of-the-period industry book-to-market, measured as the sum of the book values
of all the firms in the industry divided by the sum of their market values. The regressions are
conducted at both monthly and annual frequencies. The first row is from Table 2 of Pontiff and
Schall (1999). Panel B reports the predictive regressions of value-weighted industry returns on
the value spread, VP, measured as the difference in log book-to-market between portfolio High
and portfolio Low constructed with the two-by-three sort of Fama and French (1993). Panel C
reports the predictive regression of value-weighted industry returns on the demeaned aggregate
productivity and the cross-sectional volatility of firm-level return, σrtc . All the model statistics are
obtained by averaging results across 100 simulations. The slopes and adjusted R2 ’s are in percent.
The t-statistics are adjusted for heteroscedasticity and autocorrelation up to 12 lags.
t+1 = a + b × (k/v )t + t+1

Panel A: Rvw e
Monthly Annual
b t-stat Adj-R2 b t-stat Adj-R2
Data 0.030 − 1.00 0.422 − 16.00

Model 0.036 (3.97) 1.65 0.457 (5.83) 17.62
t+1 = a + b × VPt + t+1

Panel B: Rvw
Monthly Annual
b t-stat Adj-R2 b t-stat Adj-R2
Model 0.057 (4.42) 2.04 0.714 (6.41) 26.30
vw = a + b × (x − x̄) + c × σ c +
Panel C: Rt+1 t rt t+1
Monthly Annual
b c Adj-R2 b c Adj-R2
Slopes 3.938 2.619 19.18 −3.018 4.901 28.04
t-stat (6.39) (7.31) (−0.812) (2.92)
since pt is a separate state variable. Panel C in Table VI confirms this prediction

of the model using the cross-sectional stock return volatility as a predictor of
future industry cost of capital. This mechanism can potentially explain the new
evidence in Goyal and Santa-Clara (2003) that there is a significantly positive
relation between average stock variance, which is mostly idiosyncratic, and the
market return.
The strength of these equilibrium effects depends positively on the inverse
price elasticity of demand η. In particular, if η = 0, then the output price is
constant and there will be no equilibrium channel through which µt can affect
risk and return. In contrast, if η is high, then a small change in the industry
output will induce a large change in the output price and the firm-level cash
f lows, and hence also in risk and expected return. In sum:
HYPOTHESIS 5: The industry cost of capital increases with measures of cross-

sectional dispersion of returns within the industry; the magnitude of this cor-
relation increases with the inverse price elasticity of demand for the industry
product.
That the cross section of firms is endogenous and time-varying is a distinctive

feature of my model. In BGN, firms are independent from each other when mak-
ing optimal decisions, hence no equilibrium effect is at work. In GKZ, growth
options are assumed to be equal across firms. This enables them to characterize
the aggregate economy separately from the cross section of firms. In contrast,
I build my model from a microfoundation and arrive at the aggregate econ-
omy by integrating over the endogenous cross-sectional distribution of firms.
This distribution in turn affects the aggregate variables through equilibrium
conditions (e.g., Krusell and Smith (1998)).
IV. Link to the Literature

My work belongs to a growing strand of applied theoretical literature, pio-
neered by Berk et al. (1999). The ultimate goal is to construct a unified frame-
work that meets the challenge posed by Fama (1991): “In the end, I think we
can hope for a coherent story that (1) relates the cross-section properties of ex-
pected returns to the variation of expected returns through time and (2) relates
the behavior of expected returns to the real economy in a rather detailed way”
(p. 1610). This agenda is in stark contrast to that of behavioral finance, which
aims to link expected returns to psychological biases rather than economic fun-
damentals in the real economy.
The advantages of the rational expectations approach are arguably twofold.
Empirically, the real economy seems easier to measure than, say, investor sen-
timent. Derived from first principles, the predictions from structural models
are also more robust to alternative assumptions theoretically. This scientific
approach has a long tradition in economics. Lucas (1977) describes the task
of business cycle theorists as follows: “One exhibits understanding of business
cycles by constructing a model in the most literal sense: a fully articulated artifi-
cial economy which behaves through time so as to imitate closely the time series
behavior of actual economies” (p. 11, original emphasis). It is only natural for
finance theorists to apply this methodology to understand the behavior of risk
and expected returns by relating them to the real economy in a rather detailed
way.22
Besides Berk et al. (1999) and GKZ, other related work includes Berk (1995),
who points out a more direct mechanism linking size and book-to-market to
expected returns based on the definition of returns. My paper differs in that
my well-specified model can reveal more fundamental determinants of risk and
expected returns.
22
Zin (2002) also argues forcefully for the importance of structural modeling in understanding
asset pricing anomalies.
Lettau and Ludvigson (2001) document that value stocks have higher con-
sumption betas than growth stocks in bad times when the price of risk is high.23
This cyclical pattern greatly improves the performance of conditional asset pric-
ing models in accounting for the cross-section of average returns. However, they
do not discuss the exact mechanism driving the cyclical behavior of value and
growth betas.
Other related papers include Cochrane (1991, 1996), who provides earlier
tests of the investment-based asset pricing models using aggregate market and
size portfolios. Carlson, Fisher, and Giammarino (2004) highlight the role of op-
erating leverage in generating the book-to-market effect. Cooper (2003) argues
that the excess capacity in a distressed firm allows it to easily expand produc-
tion in response to positive aggregate shocks, giving rise to high systematic risk
for value firms. Finally, Gomes, Yaron, and Zhang (2003) investigate the role of
financial constraints in explaining the size and book-to-market effects.
V. Conclusion
Following the real business cycle tradition of Kydland and Prescott (1982)
and Long and Plosser (1983), I show how certain very ordinary economic prin-
ciples lead value-maximizing firms to choose investment plans that display
many empirical regularities in the cross section of returns. Most notably, costly
reversibility and the countercyclical price of risk deprive value firms of f lexibil-
ity in cutting capital, causing them to be riskier than growth firms, especially
in bad times when the price of risk is high. The value anomaly, interpreted by
DeBondt and Thaler (1985) and Lakonishok et al. (1994) as irrational overre-
action, is therefore in principle consistent with rational expectations.
Future research in this area is certainly called for. Theoretically, the neoclas-
sical framework can be extended to link asset prices to other features of the real
economy, for example, learning by doing, capacity utilization, entry and exit,
vintage capital, endogenous technological progress, human capital, corporate
governance, payout policy, and financial constraints. These topics have been
analyzed in depth in the literature on corporate policies, business cycle, and
economic growth, but their asset prices implications have been largely ignored.
This state of affairs seems less than desirable, since this line of work can shed
further light on the microfoundation of capital markets anomalies.
Rational expectations has solid theoretical foundation. By solving all the
endogenous variables as functions of economic primitives from optimization
behavior, simulation results are immune to the simultaneity or endogeneity
23
The debate is ongoing whether value and growth betas display the predicted business cycle
properties empirically. Lakonishok et al. (1994, p. 1569) contend that “performance in extreme
bad states is often the last refuge of those claiming that a high return strategy must be riskier,
even when conventional measures of risk such as beta and standard deviation do not show it”
(original emphasis). However, Petkova and Zhang (2003) show that they define good and bad times
by sorting on the ex post realized market excess returns, as opposed to the more theoretically
justifiable expected market risk premium. As a result, their procedure biases the estimates of
business cycle sensitivities of value and growth betas toward zero.
problem that plagues most empirical studies (e.g., Sargent (1980)). However, a
promising literature should have both theoretical and empirical applications.
Despite careful calibration and sensitivity analysis, predictions from model sim-
ulations hold only in theory, and not necessarily in reality. These predictions can
nevertheless serve as new refutable hypotheses, stimulating future empirical
research.
In my application, a popular interpretation of the value effect, suggested by
Fama and French (1993, 1996), is that book-to-market is a proxy for a state
variable associated with relative financial distress. As value stocks are typi-
cally in distress, if a credit crunch comes along, these stocks will do very badly
and hence are risky. A sizable literature has since developed to test this dis-
tress hypothesis, but the evidence is mixed at best. In contrast, the mechanism
advocated here is based on costly reversibility, a technological, not financial,
friction. Firm-level empirical analysis along this line seems warranted.
Appendix A: Proofs
Proof of Proposition 1: Rewrite the value function (8) at the optimum as vjt =
djt + Et [Mt+1 vjt+1 ]. Rearranging yields the usual asset pricing relation
1 = Et [M t+1 R j t+1 ]. (A1)
The beta-pricing relation (12) then follows by its well-known equivalence

with (A1) (e.g., Cochrane (2001, p. 19)). Q.E.D.
THEOREM 1 (Hopenhayn (1990, 1992)): Let the aggregate demand be P(Y).

An industry equilibrium exists if: (a) X and Z are compact metric spaces;
(b) Qx (xt+1 | xt ) and Qz (zt+1 | zt ) are continuous transition functions; (c) technol-
ogy has decreasing returns to scale and the technology set has a closed graph;
(d) P(Y) is weakly decreasing in Y and is measurable with respect to the in-
formation filtration generated by x and z; (e) P(Y) is uniformly bounded above
and β-integrable; (f ) for any initial measure µ0 there exists at least one feasible
allocation; and (g) limB→∞ ||π|| = ∞ where π denotes profits. If in addition (h)
the profitable function is separable in the form π (k, z; x, p) = h1 (x, z)h2 (k, p) for
some functions h1 and h2 , then the industry equilibrium above is unique and
stationary and exhibits positive entry and exit.
Proof of Proposition 2: The uniqueness and existence of the value function

result from the Contraction Mapping Theorem. The continuity, monotonicity,
and concavity of v in k follow from Lemma 9.5 and Theorem 3.2 in Stokey and
Lucas (1989). The continuity and monotonicity of v in x, p, and z follow from the
continuity and monotonicity of π in x and z and the monotonicity of the Markov
transition functions, Qx and Qz .
It is straightforward to verify that conditions (a) through (g) in Theo-
rem 1 hold in the model. Moreover, the profit function given by (7) satisfies
condition (h) in Theorem 1. Thus, the industry equilibrium exists and is also
unique. Q.E.D.
Appendix B: Computation
The primary obstacle in solving the model stems from the endogeneity of the
log output price pt , which depends upon the cross-sectional distribution of firms,
a high-dimensional object. To know future prices, it is necessary to know how
the total industry output evolves. Since investment decisions do not aggregate,
the total capital stock, and hence output, is a nontrivial function of all moments
of the current distribution of firms.
I follow the “approximate aggregation” idea of Krusell and Smith (1998). I as-
sume that firms are imperfect in their perceptions of how the price evolves over
time, and then progressively increase the sophistication of these perceptions
until the errors that the firms make become negligible.24
Suppose that firms do not perceive current or future output prices as depend-
ing on anything more than the first L moments of µ, denoted by mL , in addition
to x. Firms perceive the law of motion for mL as a function L , which expresses
the vector of L moments in the next period as a function of these moments in
the current period: mLt+1 = L (mLt , xt , xt+1 ). Given the law of motion, L , each
firm’s optimal investment decision can then be represented by a decision rule,
iL . Given such a rule and an initial capital stock and idiosyncratic productivity
distribution, it is possible to derive the implied time-series path of the firm dis-
tribution by simulating the behavior of a large number of firms. The resulting
distributions can be used to compare the simulated evolution of the specific
vector of moments mL to the perceived law of motion for mL , on which firms
base their behavior. The approximate equilibrium is a function L∗ that when
taken as given by the firms yields a fit that is close to perfect, in the sense that
L∗ tracks the behavior of mL in the simulated data almost exactly, that is, with
only very small errors. In short, in a computed, approximate equilibrium, firms
do not take into account all the moments of the cross-sectional distribution, but
the errors in forecasting prices that result from this omission are extremely
small.
The solution algorithm amounts to the following iterative procedure: (1) Se-
lect L. (2) Guess a parameterized functional form for L and on its parameters.
(3) Solve the firm’s optimal investment problem, given L . This step, which
uses value function iteration, is described in detail below. (4) Use firms’ in-
vestment rule to simulate the behavior of N firms over a large number, T, of
periods. (5) Use the stationary region of the simulated data to estimate a set of
parameters for the assumed functional form. At this stage, I obtain a measure
of goodness-of-fit or the magnitude of forecasting errors. (6) If the estimation
24
Miao (2003) proves that in a general framework, of which the Krusell and Smith (1998) econ-
omy is a special case, the competitive equilibrium can be characterized using the computed equi-
librium from the approximate aggregation algorithm, provided that the competitive equilibrium is
unique. My model satisfies this uniqueness condition by Proposition 2.
gives parameter values that are very close to those in the last iteration and the
goodness-of-fit is satisfactory, stop. If the parameter values have converged but
the goodness-of-fit is not satisfactory, increase L or try a different functional
form for L .
In my application, the special structure of the model makes the choice of L
and the identity of mL particularly easy. Since, by construction, the output price
summarizes all the information in µ that is relevant for the optimal decision
(or µ impacts on firms only indirectly through p), I let mL = p and thus L = 1. I
still have to specify a parametric law of motion for the log output price, however.
I assume that the the log output price follows a linear functional form,25
pt+1 = δ1 + δ2 pt + δ3 (xt − x) + δ4 σk , (B1)
where σk is used to capture the dependence of the log price on the cross-sectional
dispersions of firm characteristics. The aggregate productivity, xt , is also used
as a predictor for the future price because total industry output depends on
it, and the cross-sectional distribution itself is varying with x. Finally, I also
use the lagged price to capture any autoregressive effects. I include 5,000 firms
and 12,000 periods at a monthly frequency and discard the first 2,000 periods
of data. Typically, the initial firm distribution is one in which all firms hold the
same level of capital stock, and idiosyncratic shocks are drawn independently
from the unconditional,
normal distribution of z process with mean zero and
volatility σz / 1 − ρz . The initial value for the vector of coefficients in (B1) is
such that δ2 is one and all other coefficients are zero. The final results are not
sensitive to changes in the initial values.
With benchmark parameterization, I obtain the following approximate
equilibrium:
pt+1 = 0.0486 + 0.9821 pt − 0.1173(xt − x) + 0.0040σk + et+1
R 2 = 0.9994 σ = 0.0012. (B2)
As expected, the aggregate productivity and the industry output price are
negatively correlated, since when xt goes up, total industry output rises, and
drags down price along with the industry demand function. In addition, the
log output price seems very persistent, as indicated by the high autoregressive
coefficient.
Equation (B2) reports two measures of aggregation quality: R2 and the stan-
dard deviation of the forecasting error, σ . In terms of these two measures, the
quality of approximation seems extremely good. The quality is also confirmed
in Figure B.1. Panel A plots the times series of the actual price against that of
the predicted price. If the forecasting errors are small, then all the observations
should lie on the 45◦ line, which is indeed approximately the case in Panel A.
25
Krusell and Smith (1998) assume a log-linear functional form for aggregate capital stock. I
find that using output price instead of aggregate capital in my model formulation yields higher
precision for the approximate equilibrium than using aggregate capital. The R2 from (B1) with p
replaced by aggregate capital is only 75%.
Panel A: Predicted versus Actual Price Panel B: 100× Excess Demand/Output

1.08 400
350
1.06
300
Actual Output Price
1.04
250
Frequency
1.02
200
1 150
100
0.98
50
0.96
0
0.96 0.98 1 1.02 1.04 1.06 1.08 −0.2 −0.15 −0.1 −0.05 0 0.05 0.1 0.15 0.2
Predicted Output Price Excess Demand As a Precentage of Actual Output
Figure B.1. Quality of aggregation. This figure plots the time series of the actual output price as
a function of the predicted output price in Panel A, and plots the histogram of the time series of the
excess demand as a percentage fraction of the actual output in Panel B. I simulate 12,000 monthly
periods of data from the approximate equilibrium. The first 2,000 observations are discarded and
the plots are produced using the remaining 10,000 observations. In Panel A, both price series are
scaled so that their time series averages equal 1.
Panel B of Figure B.1 plots the excess demand as a percentage fraction of actual
output. In a simulation of 10,000 periods, all observations have excess demand
less than 0.2% of the actual output.
I use the value function iteration procedure to solve the individual firm’s prob-
lem. The standard log-linearization method does not work in the current frame-
work, since the idiosyncratic shock in the cross section is too large. The value
function and the optimal decision rule are solved on a grid in a discrete state
space. I specify a grid with 50 points for the capital stock with an upper bound k
(large enough to be nonbinding at all times). I construct the grid for capital stock
recursively, following McGrattan (1999), that is, ki = ki−1 + ck1 exp(ck2 (i − 2)),
where i = 1, . . . , 50 is the index of grid points and ck1 and ck2 are two constants
chosen to provide the desired number of grid points and k, given a prespeci-
fied lower bound k. The advantage of this recursive construction is that more
grid points are assigned around k, where the value function has most of its
curvature.
The state variables x and z are defined on continuous state spaces, which
have to be transformed into discrete state spaces. Since both productivity pro-
cesses are highly persistent in monthly frequency, I use the method described in
Rouwenhorst (1995). The method of Tauchen and Hussey (1991) does not work
well when persistence is higher than 0.90. I use 11 grid points for x process and
15 points for z process. In all cases the results are robust to finer grids. Finally,
the space of the log output price p needs to be transformed into a discrete space
as well. I use an even-spaced grid for p with five points. The lower and upper
bounds for p are chosen so that the simulated path of the log output price never
steps outside the bounds. The transition probability matrix for p is constructed
as follows: Given pt , xt , and µt , I calculate pt+1 from the approximate law of

motion (B1), then the probability of hitting one of the five grid points, say pi , is
5
set to be (1/| pi − pt+1 |)/ i=1 (1/| pi − pt+1 |). The idea is that the closer pi is to
pt+1 , the higher the probability that pt+1 will hit pi .
Once the discrete state space is available, the conditional expectation oper-
ator in (8) can be carried out simply as a matrix multiplication. The expected
return Et [Rt+1 ] = Et [vt+1 ]/(vt − dt ) can be calculated in the same way. Piecewise
linear interpolation is used extensively to obtain firm value, optimal invest-
ment, and expected return, which do not lie directly on the grid points. Finally,
I use a simple discrete, global search routine in maximizing the right-hand side
of the value function (8). The objective function is computed on an even-spaced
grid of k, with boundary [k, k] with 20,000 points. The computer programs for
solving the value function and the industry equilibrium are available upon
request.
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THE JOURNAL OF FINANCE • VOL. LX, NO.

The Value Premium

∗ William E. Simon Graduate School of Business Administration, University of Rochester. This

Yet, despite frequent claims of inefficient markets, what is missing, it seems,

improves the performance of the conditional asset pricing models; my contribu-

ASSUMPTION 1: The aggregate productivity shock has a stationary and monotone

xt+1 = x(1 − ρx ) + ρx xt + σx εt+1

ASSUMPTION 2: The idiosyncratic productivity shocks, denoted by zjt , are uncor-

z j t+1 = ρz z j t + σz ε zjt+1 , (2)

Both aggregate and idiosyncratic shocks are necessary to generate a nontriv-

A.2. Stochastic Discount Factor

log M t+1 = log β + γt (xt − xt+1 ) (4)

γt = γ0 + γ1 (xt − x), (5)

A.3. Industry Demand

B.1. Value Maximization

π(kt , z t ; xt , pt ) = e xt +z t + pt ktα − f , (7)

kt+1 = it + (1 − δ)kt , (9)

where it denotes investment at time t and δ is the constant depreciation rate.

θt ≡ θ + · χ{it ≥0} + θ − · χ{it <0} (11)

B.2. Beta and Expected Return

Et [R j t+1 ] = R f t + β j t λmt , (12)

R j t+1 ≡ vj t+1 /(vj t − d j t ) (13)

θt ≡ θ + · χ{it ≥0} + θ − · χ{it <0}

Proof: See Appendix A.

µt+1 (; xt+1 ) = T (, (kt , z t ); xt )µt (kt , z t ; xt ), (16)

where the operator T is defined as

Although the exact condition is somewhat technical, the underlying intuition

r Product market clearing

Proof: See Appendix A.

II. Main Findings

Group I Group II Group III

quantitative studies: capital share α; depreciation δ; persistence ρx and con-

µm ≡ [γ0 + γ1 (xt − x̄)](1 − ρx )(xt − x̄), (22)

σm ≡ σx [γ0 + γ1 (xt − x̄)]. (23)

of 28.6%, approximately the average of 25% reported by Campbell et al. (2001)

Moments Model Data

Average annual Sharpe ratio 0.41 0.43

Panel A: Data and Benchmark Panel B: Comparative Statics

Data Benchmark Model 1 Model 2

Panel A. Panel B. Panel C. Panel D.

Panel E. Panel F. Panel G. Panel H. Panel I.

Panel A: Return on Equity (ROE) Panel B: Time-Series of ROE

0.3 Growth 0.4

C.2. Corporate Investment

Panel A: Bad Times Panel B: Good Times

plot the cross-simulation average results in Figure 3.18 Figure 3 demonstrates

C.3. Risk as Inflexibility

Panel A: Expected Value Premium Panel B: The Value Spread

Figure 4. Time-varying spreads in expected excess return and in book-to-market be-

0.18 0.18 1.03

0.04 0.04 0.97

0.02 0.02 0.96

HYPOTHESIS 3: The cross-industry correlation between the degree of asymmetry

III. Further Implications

Panel A: Predictive Regressions

The Value Premium

−0.25 0.01 0.60 −4.19 0.13 8.84

Panel B: Correlation Matrix

B. Predictability of the Industry Cost of Capital

t+1 = a + b × (k/v )t + t+1

µt+1 (; xt+1 ) = T (, (kt , z t ); xt )µt (kt , z t ; xt ), (16)

t+1 = a + b × (k/v )t + t+1

t+1 = a + b × VPt + t+1