Risk and Return in Production
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This paper investigates the nature of the risk-return tradeoff facing firms. The model is derived from a firm’s intertemporal profit maximization condition under uncertainty with the short-run variable cost function and is framed in the context of a production-based asset pricing model. We identify output growth, the investment-capital ratio, variable input price growth, and technology shocks as the fundamental factors governing the risk-return tradeoff over time and across equities. We find that the investment-capital ratio captures the influence of business cycle fluctuations as well as the role of firm size and the book-to-market ratio in equity returns. Finally, we examine a joint link between capital investment and equity returns using Tobin’s Q, and show that while investment determines equity returns,it responds negatively to changes in the risk premium.
Abstract
This paper investigates the nature of the risk-return tradeoff facing firms. The model is derived from a firm’s intertemporal profit maximization condition under uncertainty with the short-run variable cost function and is framed in the context of a production-based asset pricing model. We identify output growth, the investment-capital ratio, variable input price growth, and technology shocks as the fundamental factors governing the risk-return tradeoff over time and across equities. We find that the investment-capital ratio captures the influence of business cycle fluctuations as well as the role of firm size and the book-to-market ratio in equity returns. Finally, we examine a joint link between capital investment and equity returns using Tobin’s Q, and show that while investment determines equity returns,it responds negatively to changes in the risk premium.
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