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I document the empirical evidence showing that the size premium only exists when the median book-to-market ratios in the market is high. I argue that this evidence supports the hypothesis that the size effect is a consequence of market frictions and not a risk factor priced in equilibrium. High discount rates lower stock valuations and increase the overall book-to-market ratios in the market. They are also associated with the low risk bearing capacity, limited risk sharing and high uncertainty that increase market frictions. Ranking the years in book-to-market quantiles, as a proxy for discount rates, reveals that the size premium is usually statistically significant exclusively in the top book-to-market quantile. This evidence is robust to changes in the number of quantiles; in the US in different sub periods, and in the UK; considering both the Fama/French SMB factor or the individual size portfolios; and also controlling for market risk.

Discount Rates, Market Frictions, and the Mystery of the Size Premium