Constructing Asset Pricing Models with Specific Factor Loadings

15 Pages Posted: 3 Jun 2012

See all articles by Ian Davidson

Ian Davidson

University of Sussex

Qian Guo

London School of Economics & Political Science (LSE)

Xiaojing Song

affiliation not provided to SSRN

Mark J. Tippett

Loughborough University - Business School; University of Exeter Business School

Date Written: June 2012

Abstract

We demonstrate how one can build pricing formulae in which factors other than beta may be viewed as determinants of asset returns. This is important conceptually as it demonstrates how the additional factors can compensate for a market portfolio proxy that is mis‐specified, and also shows how such a pricing model can be specified ex ante. The procedure is implemented by first selecting an ‘orthogonal’ portfolio which falls on the mean‐variance efficient frontier computed from the empirical average returns, variances and covariances on the equity securities of a large sample of firms. One then determines the inefficient index portfolio which leads to a vector of betas that when multiplied by the average return on the orthogonal portfolio, and which when subtracted from the vector of average returns for the firms comprising the sample, yields an error vector that is equal to the vector of numerical values for the variables that are to form the basis of the asset pricing formula. There will then be a perfect linear relationship between the vector of average returns for the firms comprising the sample, the vector of betas based on the inefficient index portfolio and such other factors that are deemed to be important in the asset pricing process. We illustrate computational procedures using a numerical example based on the quality of information contained in published corporate financial statements.

Keywords: Accruals quality, Average return, Beta, Capital asset pricing model, Inefficient portfolio, Market‐to‐book ratio, Size

Suggested Citation

Davidson, Ian and Guo, Qian and Song, Xiaojing and Tippett, Mark J., Constructing Asset Pricing Models with Specific Factor Loadings (June 2012). Abacus, Vol. 48, Issue 2, pp. 199-213, 2012. Available at SSRN: https://ssrn.com/abstract=2073076 or http://dx.doi.org/10.1111/j.1467-6281.2012.00361.x

Ian Davidson

University of Sussex

Sussex House
Falmer
Brighton, Sussex BNI 9RH
United Kingdom

Qian Guo

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Xiaojing Song

affiliation not provided to SSRN

No Address Available

Mark J. Tippett

Loughborough University - Business School ( email )

Ashby Road
Loughborough
Nottingham NG1 4BU, LE11 3TU
Great Britain

University of Exeter Business School ( email )

Streatham Court
Xfi Building, Rennes Dr.
Exeter, EX4 4JH
United Kingdom

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