A Production-Based Asset Pricing Model With R&D Investment

We develop a pure production-based asset pricing model, in which a representative firm conducts research and development (R&D) investment to try to increase future productivity. The firm has to make a trade-off between gain and loss of R&D investment. With the ability that the firm can transform productivity across states of nature, in equilibrium, the marginal loss of R&D investment equals the expected marginal gain of increasing future natural productivity, and the firm’s marginal rate of substitution on R&D investment implies a valid stochastic discount factor. Empirically, our models well fit market excess return and risk-free rate with plausible parameter values, and do a reasonable job explaining the cross-sectional variation in average stock returns