We propose a general equilibrium model to study the link between the cross section of expected returns and book-to-market characteristics. We model two primitive assets: value assets and growth assets that are options on assets in place. The cost of option exercise, which is endogenously determined in equilibrium, is highly procyclical and acts as a hedge against risks in assets in place. Consequently, growth options are less risky than value assets, and the model features a value premium. Our model incorporates long-run risks in aggregate consumption and replicates the empirical failure of the conditional capital asset pricing model (CAPM) prediction. The model also quantitatively accounts for the pattern in mean returns on book-to-market sorted portfolios, the magnitude of the CAPM-alphas, and other stylized features of the cross-sectional data.

We extend the neoclassical investment model (Hayashi, 1982) to allow for limited commitment on compensation contracts. We consider three types of limited commitment: (i) managers cannot commit to compensation contracts that provide lower continuation utility than their outside options; (ii) shareholders cannot commit to negative net present value (NPV) projects; (iii) both the managers and the shareholders cannot commit. We characterize the optimal contract under general convex adjustment cost functions and provide examples for which closed-form solutions can be obtained. We show that, as in the data, small firms invest more, grow faster, and have a higher Tobin׳s Q than large firms under the optimal contract. In addition, the pattern of the dependence of chief executive officer (CEO) compensation on past performance implied by our model is also consistent with empirical evidence.

To understand the link between financial intermediation activities and the real economy, we build a general equilibrium model in which agency frictions in the financial sector affect the efficiency of capital reallocation across firms and generate aggregate economic fluctuations. We develop a recursive policy iteration approach to fully characterize the nonlinear equilibrium dynamics and the off-steady-state crisis behavior. In our model, adverse shocks to agency frictions exacerbate capital misallocation and manifest themselves as variations in total factor productivity at the aggregate level. Our model endogenously generates countercyclical volatility in the aggregate time series and countercyclical dispersion in the marginal product of capital and asset returns in the cross-section.

Using the expected option-implied variance reduction to measure the sensitivity of stock returns to monetary policy announcement surprises, this paper shows monetary policy announcements require significant risk compensation in the cross section of equity returns. We develop a parsimonious equilibrium model in which FOMC announcements reveal the Federal Reserve’s private information about its interest-rate target, which affects the private sector’s expectation about the long-run growth-rate of the economy. Our model accounts for the dynamics of implied variances and the cross section of the monetary policy announcement premium realized around FOMC announcement days.