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Do Investment-Based Models Explain Equity Returns? Evidence from Euler Equations

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  • Stefanos Delikouras
  • Robert F Dittmar

Abstract

We investigate the empirical implications of the investment-based model of asset pricing for the Hansen-Jagannathan and Kozak-Nagel-Santosh discount factors in the linear span of equity returns. We find that the stochastic discount factors satisfying the Euler equation for equity returns cannot satisfy the Euler equation for investment returns because returns on corporate investment covary inversely with the sources of equity risk relative to returns on equity. As a result, the model fails to replicate the level of the risk premium. Our results suggest that joint restrictions on the optimality of investment and consumption pose stringent conditions for candidate production models.

Suggested Citation

  • Stefanos Delikouras & Robert F Dittmar, 2022. "Do Investment-Based Models Explain Equity Returns? Evidence from Euler Equations," The Review of Financial Studies, Society for Financial Studies, vol. 35(8), pages 3823-3866.
    • Handle: RePEc:oup:rfinst:v:35:y:2022:i:8:p:3823-3866.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhab099
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    More about this item

    JEL classification:

    • D25 - Microeconomics - - Production and Organizations - - - Intertemporal Firm Choice: Investment, Capacity, and Financing
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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