Interpreting Risk Premia Across Size, Value, and Industry Portfolios

In this paper, we model cash flow and consumption growth rates as a vectorautoregression (VAR), from which we measure the response of cash flow growth to consumption shocks. As the appropriate cash flow proxy is not unambiguous, nor likely to be measured without error, we consider three alternatives for portfolio cash flows: cash dividends, dividends plus repurchases and corporate earnings. We find that the long-run exposure of cash flows to aggregate consumption risk can justify a significant degree of the observed variation in risk premia across size, book-to-market, and industry sorted portfolios. Also, our economic model highlights the reasons for the failure of the market beta to justify the cross-section of risk premia. Most importantly, our results indicate that measured differences in the long-run exposures of cash flows to aggregate economic fluctuations as captured by aggregate consumption movements contain very valuable information regarding differences in risk premia. In all, our results indicate that the size, book-to-market and industry spreads are not puzzling from the perspective of economic models.