Cash-flow Risk, Discount Risk, and the Value Premium∗

We propose a general equilibrium model with multiple assets able to match both the time series and the cross-sectional predictability of stock returns. The cross section of average returns is determined by both cash-flow risk and discount risk. We show that if cross-sectional differences in average returns are mainly determined by discount risk, then a counterfactual prediction obtains: Assets with high values normalized by cash-flows – growth stocks – command a high premium relative to value stocks. Using our model, we find that a strong cross-sectional variation in cash flow risk is necessary to obtain a quantitatively plausible value premium. In addition, general equilibrium restrictions on the market portfolio also generate the value premium puzzle, that is, the inability of the CAPM to explain the cross section of average returns of price sorted portfolios. We use the model to interpret the Fama and French (1993) model, and, in particular, to offer an interpretation of the HML factor. ∗VERY PRELIMINARY AND INCOMPLETE. PLEASE DO NOT CIRCULATE WITHOUT PERMISSION.