Working Paper: CEPR ID: DP11031
Authors: Tobias Adrian; Evan Friedman; Tyler Muir
Abstract: Standard factor pricing models do not capture the common time series or cross sectional variation in average returns of financial stocks well. We propose a five factor asset pricing model that complements the standard Fama-French (1993) three factor model with a financial sector ROE factor (FROE) and the spread between the financial sector and the market return (SPREAD). This five factor model helps to alleviate the pricing anomalies for financial sector stocks and also performs well for nonfinancial sector stocks when compared to the Fama-French (2014) five factor or the Hou, Xue, Zhang (2014) four factor models. We find the aggregate expected return to financial sector equities to correlate negatively with aggregate financial sector ROE, which is puzzling, as ROE is commonly used as a measure of the cost of capital in the financial sector.
Keywords: Asset Pricing; Cost of Capital; Financial Intermediation
JEL Codes: G12; G21; G24; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Return on Equity (ROE) (D33) | Expected Returns (G17) |
| Increased Risk-Taking (D91) | Return on Equity (ROE) (D33) |
| Increased Risk-Taking (D91) | Expected Returns (G17) |
| Higher Risk Appetite (Aggregate) (D81) | Market Price of Risk (G19) |
| Market Price of Risk (G19) | Expected Returns (G17) |
| Leverage Growth (O00) | Future Returns (G17) |
| Five-Factor Financial Capital Asset Pricing Model (FCAPM) (G19) | Expected Returns (G17) |
| ROE Factor (C29) | Expected Returns (G17) |
| Spread Factor (C46) | Expected Returns (G17) |
| Increased Risk-Taking (Institution Level) (D81) | Expected Returns (Aggregate Level) (G17) |