Cash Flow, Consumption Risk, and the Cross-section of Stock Returns


  • ZHI DA

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    • Mendoza College of Business, University of Notre Dame. E-mail: This paper is based on Chapter 1 of my Ph.D. thesis at Northwestern University. I wish to thank Torben Andersen, Ravi Bansal, Jason Chen, Long Chen, Kent Daniel, Martin Eichenbaum, Richard Evans (WFA discussant), Fangjian Fu (EFA discussant), Paul Gao, Campbell Harvey (the editor), Robert Korajczyk, Arvind Krishnamurthy, Deborah Lucas, Christian Lundblad, Robert McDonald, Christopher Polk, Ernst Schaumburg, Paul Schultz, George Skoulakis, Yong Wang; two anonymous referees; seminar participants at the Federal Reserve Bank of New York, Lehman Brothers, Washington University in St. Louis, the Eastern Finance Association (EFA) 2006 Annual Meeting, and the Western Finance Association (WFA) 2006 Annual Meeting; and especially Ravi Jagannathan for his continuing guidance and support. Nan Zhang provided excellent editorial support. I am responsible for any errors or omissions.


I link an asset's risk premium to two characteristics of its underlying cash flow: covariance and duration. Using empirically novel estimates of both cash flow characteristics based exclusively on accounting earnings and aggregate consumption data, I examine their dynamic interaction in a two-factor cash flow model and find that they are able to explain up to 82% of the cross-sectional variation in the average returns on size, book-to-market, and long-term reversal-sorted portfolios for the period 1964 to 2002. This finding highlights the importance of fundamental cash flow characteristics in determining the risk exposure of an asset.