The first essay, Knowledge Capital and Innovation Efficiency Effects on Stock Returns, provides a novel framework for understanding innovation in the asset pricing literature. Prior research shows that stock returns are increasing in firms' innovative efficiency. In a dynamic model of investment in physical and knowledge capital, this effect can arise rationally as innovative efficiency amplifies risks associated with investment and investors require compensation for these risks. I identify operating leverage and expansion option channels as the main drivers of the risk premium. Simulations of panels of firms with heterogeneous technology can reproduce the economic magnitude of the empirical return effect. The model further implies that the effect should be stronger for firms with high operating leverage and low book-to-market ratios. These predictions are supported by the data. The second essay, Operating Leverage, R&D Intensity, and Stock Returns, studies interaction effects of operating leverage and R&D intensity on stock returns. A production-based asset pricing model with knowledge capital has an implication that R&D intensive firms earn higher expected stock returns among high fixed costs firms. An investment strategy that bought R&D intensive firms and sold R&D weak firms earn 0.67% to 1.26% per month in high fixed cost portfolios, while the strategy is not profitable in low fixed costs portfolios. In regression analysis, one standard deviation increase in R&D expenditures is associated with 1.85% to 2.12% increase in yearly stock returns for above median fixed costs firms. By the recursive nature of knowledge capital accumulation, the value of knowledge capital itself is sensitive to the economic situation. R&D intensive firms' values aggravate faster with fixed costs in bad times and investors require compensation for the risk. In short, the value of knowledge capital itself is risky, R&D intensive firms are more exposed to the risky nature of knowledge capital, and fixed costs amplify the risk.
Knowledge capital, Research and development (R&D), Innovation, Risk premium
University of Illinois - Urbana-Champaign
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University of Illinois at Urbana-Champaign