Equilibrium Value and Size Premia

85 Pages Posted: 24 Mar 2005 Last revised: 27 Feb 2020

See all articles by Vito Gala

Vito Gala

Pacific Investment Management Company - PIMCO

Date Written: October 30, 2018

Abstract

A general equilibrium production economy with heterogeneous firms and irreversible investment generates the value premium. Investment irreversibility prevents unprofitable value firms from optimally scaling down their capital stock. In contrast, profitable and fast growing - growth - firms can optimally use investment to provide consumption insurance. Value firms are riskier and have higher expected returns than growth firms, especially in bad times when consumption volatility is high. The value premium is larger for small stocks as small value firms are more severely affected by irreversibility. Firms’ investment and capital predict the cross-section of stock returns much like book-to-market and market equity both in the model and data. The model can replicate the failure of the unconditional CAPM. Multifactor models, including the Fama and French (1993) factor model, and to a lesser extent, conditional versions of the CAPM, outperform the unconditional CAPM.

Keywords: Asset Pricing, Production, Investment, General Equilibrium

JEL Classification: G12, D91, D92, D51, C68, D21, D24

Suggested Citation

Gala, Vito, Equilibrium Value and Size Premia (October 30, 2018). AFA 2006 Boston Meetings Paper, Available at SSRN: https://ssrn.com/abstract=686889 or http://dx.doi.org/10.2139/ssrn.686889

Vito Gala (Contact Author)

Pacific Investment Management Company - PIMCO ( email )

650 Newport Center Drive
Newport Beach, CA 92660
United States

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