The Demographics of Innovation and Asset Returns

We study asset-pricing implications of innovation in a general-equilibrium overlapping-generations economy. Innovation increases the competitive pressure on existing firms and workers, reducing the profits of existing firms and eroding the human capital of older workers. Thus, innovation creates a risk factor, which we call the “displacement risk. ” Displacement risk is a systematic risk factor due to the lack of inter-generational risk sharing. We show that the standard aggregate consumption-based asset pricing model must be modified to account for inter-cohort consumption differences generated by the displacement-risk factor. This new risk factor helps explain several empirical patterns in asset returns, including the existence of the growth-value factor in returns and the value premium, and the high equity premium. Our calibration results suggest that the proposed mechanism is quantitatively consistent with the data