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What are the economic justifications of the size premium?

In factor pricing models like the intertemportal capital asset pricing model (I-CAPM) or arbitrage pricing theory (APT), it is assumed that exposure to one of these factors represent exposure to some sort of undesirable risk. In this question, I'm trying to understand how to interpret exposure to size (measured by market capitalization) as exposure to some form of common risk.

This question is related to this question about momentum: "How is momentum justified as a common risk factor?"

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The following are NOT my words. Found this online. Please check full article here:

http://www.multifactorworld.com/Lists/Posts/Post.aspx?List=3b285530-ccfa-416a-ba3b-de55213abe17&ID=59

Hope this helps...

Size Premium: Why Does it Exist? There seems to be general agreement that the size premium is a reward for bearing the risk that small companies may do poorly in bad economic environments. For example, compared to larger companies smaller companies may not be able to easily obtain credit in such environments. Bankruptcy risk is also typically a bigger risk for smaller companies in tough economic environments and in general. It could also be that some portion of the size premium is a reward for bearing the liquidity risk of small stocks compared to large stocks.

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Reasons why smaller firms may do more poorly, conditional on the same idiosyncratic shock:

  • Smaller means more focussed on one product, unable to diversify risks
  • Smaller means less capital to use as collateral
  • And hence more difficult to get funds when needed
  • Smaller typically also means younger (unless controlled for), which can mean less experience in dealing with crises, but also less trust from corporate banks
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