Winston Wei Dou

Asset Pricing with Misallocation

Joint with Yan Ji, Di Tian, Pengfei Wang

February 2021


Misallocation reduces total factor productivity and economic growth, implying substantial adverse welfare effects. Misallocation measures should therefore provide a more informative empirical stochastic discount factor than aggregate consumption time series in small samples. We find evidence for misallocation-driven low-frequency movements in both aggregate growth and stock returns. We then develop an endogenous growth model with heterogeneous firms, intermediate goods, and financial frictions, in which misallocation emerges analytically as a crucial state variable. In equilibrium, misallocation endogenously generates long-run uncertainty about economic growth by distorting innovation and R&D decisions, leading to significant welfare losses and risk premia in capital markets. Empirically, a two-factor model with market and misallocation factors prices size, book-to-market, momentum, and bond portfolios with an R-squared and a MAPE close to the Fama-French three-factor model.