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A central issue in macroeconomics is the question of how financial markets are connected to the real side of the economy. The ongoing integration of international capital markets and the repeated occurrence of large financial crises have raised the concern about this topic beyond academic circles. However, compared to the considerable amount of interest the subject attracts, as yet little is known about the interrelations between financial and macroeconomic variables.

One branch of research related to this topic deals with the question of how stock returns are linked to fluctuations of economic activity. Asset pricing theory and practice have long been dominated by market-inherent measures of risk. A classic result, the capital asset pricing model (CAPM), models an asset’s expected return as a function of its past exposure to the market risk. Despite its simplicity, the CAPM in general works well in empirical tests. However, it fails to explain certain patterns in the cross-section of asset returns. For example, it has been shown that small stocks in terms of market capitalization on average earn higher returns than big stocks, even after accounting for the market risk. Also, stocks of firms whose book value is high compared to its market value on average exhibit higher returns than stocks with a low book-to-market equity ratio.