A General Equilibrium Model of the Value Premium with Time-Varying Risk Premia

Abstract

A simple general equilibrium production economy matches moments of the value premium and equity premium. Value firms have low productivity, but will eventually produce high cash flows. The present value of these temporally distant cash flows is especially sensitive to equity premium movements. The value premium is the reward for bearing this sensitivity. Capital adjustment costs are important. Without these costs, value firms would disinvest heavily, leading to high cash flows today, low cash flow growth going forward, and small exposure to discount rate shocks. Empirical evidence verifies that value firms have higher cash flow growth and supports other predictions.

Keywords: Equity Premium Puzzle, Value Premium, Production, Time-varying Consumption Volatility

JEL Classification: G10, E20, E30