Air pollution and stock returns: The cash flow risk channel

Abstract

This paper provides a novel explanation regarding the phenomenon that high local air pollution forecasts a low risk premium at the firm-level. Using Chinese stock market data, we show that there is a negative correlation between air pollution and stock return. Further empirical analysis reveals that pollution affects the stock market by changing the covariance between cash flows and the aggregate profitability shock. This result can be illustrated by a neoclassical q-theory model with air pollution as a factor affecting production.