Capital, Contracts and the Cross Section of Stock Returns∗

We present a tractable, static, general equilibrium model with multiple sectors in which firms offer workers incentive contracts and simultaneously raise capital in stock markets. Workers optimally invest in the stock market and at the same time hedge labor income risk. Firms rationally take agents’ portfolio decisions into account. In equilibrium, the cost of capital of each sector is endogenous. We compare the first-best, in which workers’ effort levels are observable, to an economy in which workers’ effort is observed with noise. In the presence of moral hazard, the CAPM fails because firms, by choosing optimal incentive contracts, transfer risk both through wages and through the stock market. This leads to several cross-sectional asset pricing “anomalies,” such as size and value effects. As we characterize optimal contracts, we present empirical predictions relating workers’ compensation, firm productivity, firm size and financial market abnormal returns. We also demonstrate some general equilibrium implications of endogenous contracts; for example the ex ante value of human capital can be higher in an economy with moral hazard. ∗We have benefited from helpful comments by Jonathan Berk, Paul Ehling, Adriano Rampini, Jim Wilcox and seminar participants at Berkeley, HEC Lausanne, INSEAD, Oxford Said Business School, the European Winter Finance Summit 2008, and the NBER spring asset pricing meeting 2008. †Haas School of Business, UC Berkeley, Tel: (510) 643-9391, E-mail: [email protected]. ‡Haas School of Business, UC Berkeley, Tel: (510) 643-0547, E-mail: [email protected].