Firms’ Heterogeneous Sensitivities to the Business Cycle, and the Cross-Section of Expected Returns

Francois Gourio

No WP2006-005, Boston University - Department of Economics - Working Papers Series from Boston University - Department of Economics

Abstract: In this paper, I propose and test a simple technology-based theory of firms’ sensitivities to aggregate shocks. I show that when the elasticity of substitution between capital and labor is below unity, low profitability firms are more sensitive to aggregate shocks, i.e. to the business cycle. Since the wage is smoother than productivity, revenues are more procyclical than costs, making profits, the residual procyclical. Firms with low profitability are more procyclical since the residual is smaller and the amplification greater. I study the asset pricing implications of this technology and find that it can explain the riskiness of small and “value” firms (Fama and French 1996). These firms are less profitable and are thus more procyclical. I find empirically that the cross-section of expected returns is well explained by differences in sensitivities of firms’ earnings to GDP growth, or by differences in profitability. The model yields rich empirical implications by linking a firm’s real behavior (the elasticity of output, employment and profits to an aggregate shock) to its financial characteristics (the firm’s betas and its average return). I next embed my partial equilibrium model in a full DSGE model to conduct a GE analysis. Empirically I show that firms with low margins are indeed more sensitive to the business cycle in their employment, sales or profits.

Keywords: Cross-Section of Returns; Book-to-Market; Value Premium; Productivity Heterogeneity. (search for similar items in EconPapers)
JEL-codes: E44 G12 (search for similar items in EconPapers)
Pages: 52 pages
Date: 2006-02
New Economics Papers: this item is included in nep-bec, nep-dge, nep-fin and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Working Paper: Firms' Heterogeneous Sensitivities to the Business Cycle, and the Cross-Section of Expected Returns (2006)
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