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Profitability Anomaly and Aggregate Volatility Risk

The paper shows that firms with lower profitability have lower expected returns because such firms perform better than expected when market volatility increases. The better-than-expected performance comes from the fact that unprofitable firms are distressed and volatile, and thus their equity resembles a call option on the assets. Consistent with that, the profitability anomaly is stronger for distressed and volatile firms, and aggregate volatility risk can explain this regularity.