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 argue that the cointegrating relation between dividends and consumption, a measure of long-run consumption risks, is a key determinant of risk premia at all investment horizons. As the investment horizon increases, transitory risks disappear, and the asset's beta is dominated by long-run consumption risks. We show that the return betas, derived from the cointegration-based VAR (EC-VAR) model, successfully account for the cross-sectional variation in equity returns at both short and long horizons; however, this is not the case when the cointegrating restriction is ignored. Our evidence highlights the importance of cointegration-based long-run consumption risks for financial markets.]

We develop an equilibrium model with moral hazard, which arises because some productivity shocks are privately observed by firm managers only. We characterize the optimal contract and its implications for firm size, growth, and managerial pay-performance sensitivity and exploit them to quantify the severity of the moral hazard problem. Our estimation suggests that unobservable shocks are relatively modest and account for about 10% of the total variation of firm output. Nonetheless, moral-hazard-induced incentive pay is quantitatively significant and accounts for 50% of managerial compensation. Eliminating moral hazard would result in about a 1% increase in aggregate output.

We argue that the cointegrating relation between dividends and consumption, a measure of long-run consumption risks, is a key determinant of risk premia at all investment horizons. As the investment horizon increases, transitory risks disappear, and the asset's beta is dominated by long-run consumption risks. We show that the return betas, derived from the cointegration-based VAR (EC-VAR) model, successfully account for the cross-sectional variation in equity returns at both short and long horizons; however, this is not the case when the cointegrating restriction is ignored. Our evidence highlights the importance of cointegration-based long-run consumption risks for financial markets.

Long-Run Risk (LRR) model which emphasizes the role of long-run risks, that is, low-frequency movements in consumption growth rates and volatility, in accounting for a wide-range of asset pricing puzzles. In this article we present a generalized LRR model, which allows us to study the role of cyclical fluctuations and macroeconomic-crisis on asset prices and expected returns. The Bansal and Yaron (2004) LRR model contains (i) a persistent expected consumption growth component, (ii) long-run variation in consumption volatility, and (iii) preference for early resolution of uncertainty. To evaluate the role of cyclical risks, we incorporate a cyclical component in consumption growth — this component is stationary in levels. To study financial market crisis, we also entertain jumps in consumption growth and consumptionvolatility. We find that the magnitude of risk compensation for cyclical risks in consumption critically depends on the magnitude of the inter-temporal elasticity of substitution (IES). When the IES is larger than one, cyclical risks carry a very small risk-premium and the compensation for long-run risks is large. When IES is close to zero, the risk compensation for cyclical risks is large, however, in this case the risk-free rate is implausibly high (in excess of 10 percent). Given this, it seems unlikely that the compensation for cyclical risk is of economically significant magnitude. This implication is also consistent with Robert E. Jr. Lucas (1987), who argues that economic costs of transient shocks are small and those for trend shocks are large. Moreover, Ravi Bansal, Robert F. Dittmar and Dana Kiku (2009) provide evidence from equity markets that the compensation for long-run risks is large and that for cyclical risk is quite small.

We develop a unified theory of dynamic contracting and assortative matching to explain firm dynamics. In our model, neither firms nor managers can commit to arrangements that yield lower payoffs than their outside options, which are microfounded by the equilibrium conditions in a matching market. The model endogenously generates power laws in firm size and CEO compensation, and explains differences in their right tails. We also show that our model quantitatively accounts for many salient features of the time‐series dynamics and the cross‐sectional distribution of firm investment, dividend payout, and CEO compensation.

How important are volatility fluctuations for asset prices and the macroeconomy? We find that an increase in macroeconomic volatility is associated with an increase in discount rates and a decline in consumption. We develop a framework in which cash flow, discount rate, and volatility risks determine risk premia and show that volatility plays a significant role in explaining the joint dynamics of returns to human capital and equity. Volatility risk carries a sizable positive risk premium and helps account for the cross section of expected returns. Our evidence demonstrates that volatility is important for understanding expected returns and macroeconomic fluctuations.