The Adjusted Solow Residual and Asset Returns

Abstract

It is a well-known fact that asset returns are affected not only by firm-specific risks but also by macroeconomic risks. Although firm-specific risks (diversifiable risks) can be avoided by building a good portfolio, macroeconomic risks (undiversifiable risks), owing to their nature, cannot be avoided. Since macroeconomic risks are unavoidable and yet have significant effects on the asset returns, many researchers have attempted to identify one or more variables as macroeconomic risks and have analyzed their impacts. In the empirical finance literature, macroeconomic risks are considered as factors. The first significant study in this area was conducted by Chen, Roll, and Ross [1986], who explored a set of economic variables that systematically affected asset returns. 2 Although a wide range of variables have been chosen as factors in this line of research, little consensus has been obtained on why such variables should be the factors. In other words, the existing literature often fails to provide a theoretical justification for the chosen factors, particularly when they are selected by fitting returns, rather than by deriving from explicit theoretical frameworks. This study adopts a different approach by establishing a link between theory and empirics. In particular, it identifies one of the factors based on a simple equilibrium model, and then empirically assesses its effects on asset returns. Based on an equilibrium business cycle model, this study shows that an aggregate productivity shock