An Alternative Three-Factor Model
Cheung Kong Graduate School of Business
Simon Business School, University of Rochester; National Bureau of Economic Research (NBER)
Ohio State University - Fisher College of Business; National Bureau of Economic Research (NBER)
A new factor model consisting of the market factor, an investment factor, and a return-on-equity factor is a good start to understanding the cross-section of expected stock returns. Firms will invest a lot when their profitability is high and the cost of capital is low. As such, controlling for profitability, investment should be negatively correlated with expected returns, and controlling for investment, profitability should be positively correlated with expected returns. The new three-factor model reduces the magnitude of the abnormal returns of a wide range of anomalies-based trading strategies, often to insignificance. The model's performance, combined with its economic intuition, suggests that it can be used to obtain expected return estimates in practice.
Number of Pages in PDF File: 32
Keywords: Anomalies, Alphas, Factor Regressions, Asset Pricing Tests
JEL Classification: E44, G12, G14
Date posted: May 19, 2010 ; Last revised: January 21, 2014
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