Asset Pricing with Real Investment Commitment

This paper analyzes the equilibrium efiect of investment commitment on excess returns when the representative consumer has Epstein-Zin utility. Investment commitment captures the idea that long-term investment projects require not only current expenditures but also commitment to future expenditures. The general equilibrium efiects of investment commitment and Epstein-Zin preferences generate endogenously time-varying flrst and second moments of consumption growth and stock returns. As a result, the flrst and second moments of expected excess returns are endogenously counter-cyclical, excess returns are predictable, and the equity premium increases by an order of magnitude. This paper also ofiers novel empirical flndings regarding the predictability of returns. In the model, lagged investment arises as a state variable, determining the amount of committed expenditures. In the real and simulated data, the lagged investment rate helps to forecast the mean and volatility of returns even after controlling for size and book-to-market.

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