Implied Returns and the Value Premium

Superior returns of value firms are consistent with rational expectations under costly reversibility and the countercyclical price of risk through examination of expected rates of return (k) and market risk premiums (MRP) over time. With increases in the book-to-market (B/M) ratio, both the expected rate of return (k) and expected market risk premium (MRP) generally increase. This upward trend in k and MRP appear justified as ROE (book) steadily declines with increasing B/M. Consistent with the countercyclical price of risk, k and MRP during contractions are greater than those of non-contractions. Consistent with costly reversibility, growth firms with low B/M and FATA purchase more fixed assets during both contractions and non-contractions than value firms with high B/M and FATA. Inconsistent with costly reversibility, value firms purchase more fixed assets during contractions than non-contractions