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Journal of Finance Vol. 78 No. 6 2023

Operating Hedge and Gross Profitability Premium

Leonid Kogan; Jun Li1; Harold H. Zhang2,3,4,5,6,7,8,9,10,11,12,13,14

1 The University of Texas at Dallas · 2 Conference Board · 3 Winston-Salem State University · 4 Jack Miller Center · 5 Lucas Research · 6 Suwon Research Institute · 7 Larsen & Toubro (India) · 8 Xing Wei College · 9 Fondazione Istituto G. Giglio di Cefalù · 10 Hengyang Academy of Agricultural Sciences · 11 Harrison Medical Center · 12 GGG (France) · 13 Xiaomi (China) · 14 University of Oklahoma

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Abstract

We show theoretically that variable production costs reduce systematic risk of firms' cash flows if capital and variable inputs are complementary in firms' production and input prices are procyclical. In our dynamic model, this operating hedge effect is weaker for more profitable firms, giving rise to a gross profitability premium. Moreover, gross profitability and value factors are distinct and negatively correlated, and their premia are not captured by the capital asset pricing model (CAPM). We estimate the model by simulated method of moments, and find that its main implications for stock returns and cash flow dynamics are quantitatively consistent with the data.

DOI
10.1111/jofi.13275
Volume
78
Issue
6
Pages
3387-3422
Language
en
Sources
openalex bibtex:phds-export.bib crossref

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