Operating hedge and gross profitability premium

Author / Creator

Kogan, Leonid, author

Available as

Online

Summary

We show theoretically that variable production costs lower systematic risk of firms' cash flows if capital and variable inputs are complementary in firms' production and input prices are pro-cyclic...

We show theoretically that variable production costs lower systematic risk of firms' cash flows if capital and variable inputs are complementary in firms' production and input prices are pro-cyclical. In our dynamic model, this operating hedge effect is weaker for more profitable firms, giving rise to a gross profitability premium. Moreover, gross profitability and value factors are distinct and negatively correlated, and their premia are not captured by the CAPM. We estimate the model by the simulated method of moments, and find that its main implications for stock returns and cash flow dynamics are quantitatively consistent with the data.

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