The Value Premium and the Fixed Supply of Assets

Abstract

The paper demonstrates that the mean-variance framework with fixed payoffs can explain a range of well-established empirical facts -- such as the value premium and its dependence on size and the dependence of the cross-section of stock returns on fundamental accounting variables. The proposed static partial-equilibrium model leads to an interpretation of the value premium as compensation required to induce investors to hold assets available in abundance relative to investor demand (in the absence of such compensation). Implications asset owners are significant: the value premium is not a ``free lunch,'' unless the asset owners' optimal allocation to the value asset is higher than that of the average investor. The paper reports the results of empirical tests, which confirm the dependence of CAPM beta on fundamental factors, uncover a strong dependence of a number of risk metrics on size, and lend support to the proposed model.