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
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Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number
846.
Length: Date of creation: 03 Dec 2006 Date of revision: Handle: RePEc:red:sed006:846
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
John Y. Campbell & Tuomo Vuolteenaho, 2004.
"Bad Beta, Good Beta,"
American Economic Review,
American Economic Association, vol. 94(5), pages 1249-1275, December.
[Downloadable!]
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John Y. Campbell & Tuomo Vuolteenaho, 2003.
"Bad Beta, Good Beta,"
NBER Working Papers
9509, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)
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