Contingent-claim-based expected stock returns

We develop and test a parsimonious contingent claim model for cross-sectional stock returns under no-arbitrage condition. Because stocks are residual claims on firms' assets that generate operating cash flows (Merton, 1974), stock returns are cash flow rates scaled by the sensitivities of stocks to cash flows. We adapt implied-state generalized method of moments (Pan, 2002) to test the no-arbitrage relations between stock returns and cash flow rates. Our model performs well in explaining the returns of stock portfolios formed on market leverage, book-to-market ratio, asset growth rate and equity size. The success of our model is attributed to our innovative structural estimation of the stock-cash flow sensitivities that carry economic information about a firm's financial leverage and probability of default. Specifically, value stocks, high-leverage stocks and low-asset-growth stocks are more sensitive to cash flows than growth stocks, low-leverage stocks and high-asset-growth stocks, particularly in recessions when default probabilities are high.