Choice Among Alternative Benchmarks: An Asset Pricing Approach

Abstract

This paper provides an asset pricing rationale for choosing among alternative ways to group securities in applied corporate finance settings. Explicit reference to the asset pricing paradigm has become less prevalent in the empirical corporate finance literature, where there has emerged a preference for grouping securities on the basis of the financial characteristics of the firm and on industry affiliation. We propose a new approach using basis assets that is consistent with the asset pricing paradigm and which explains significantly more of the cross sectional dispersion in asset returns using Generalized Least Squares applied on a security by security basis. A main result of our paper is that this asset-pricing-based approach justifies the use of industrial classifications to construct matched samples and appropriate benchmark performance comparisons.

Keywords: asset pricing, risk classes, industry benchmarks, basis assets

JEL Classification: G12, G32