Cash Flow, Consumption Risk and Cross Section of Stock Returns

Abstract

This paper directly links the risk premium on an asset to two characteristics of its underlying cash flow: cash flow covariance with aggregate consumption; and cash flow duration, which measures the temporal pattern of the cash flow. Their impact on the cross-sectional variation of risk premia can be largely captured by a two-factor cash flow model. While cash flow covariance is of first-order importance in explaining the cross-sectional variation of risk premia, cash flow duration still provides additional explanatory power through a second-order interaction term. Cash flow duration is particularly important in explaining the value premium given as value and growth stocks have significantly different durations. Empirically, I measure both cash flow characteristics using only consumption and accounting data. I show that the two-factor cash flow model is able to explain 82% of the cross-sectional variation in returns on size or book-to-market sorted stock portfolios.