Idiosyncratic cash flows and systematic risk, Working paper

We show that unpriced cash flow shocks contain information about future priced risk. A positive idiosyncratic shock decreases the sensitivity of firm value to priced risk factors and simultaneously increases firm size and idiosyncratic risk. A simple model can there-fore explain book-to-market and size anomalies, as well as the negative relation between idiosyncratic volatility and stock returns. Modeling idiosyncratic shocks can also produce a negative relation between growth options and risk and has additional asset pricing im-plications. More generally, our results imply that any economic variable correlated with the history of idiosyncratic shocks can help to explain expected stock returns