We construct a dynamic general equilibritim production economy to explicitly link expected stock returns to firm characteristics such as firm size and the book-to-market ratio. Stock returns in the model are completely characterized by a conditional capital asset pricing model (CAPM). Size and book-to-market are correlated with the trtie conditional market beta and tberefore appear to predict stock returns. The cross-sectional relations between firm cbaracteristics and returns can subsist even after one controls for typical empirical estimates of beta. These findings stiggest that the empirical success of size and book-to-market can be consistent with a single-factor conditional CAPM model.
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