The Cost of Capital of the Financial Sector

57 Pages Posted: 22 Dec 2015 Last revised: 17 Dec 2016

See all articles by Tobias Adrian

Tobias Adrian

International Monetary Fund

Evan Friedman

Columbia University

Tyler Muir

University of California, Los Angeles (UCLA) - Anderson School of Management; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: December 21, 2015

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 and 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 and French (2014) five factor or the Hou, Xue, and 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.

Suggested Citation

Adrian, Tobias and Friedman, Evan and Muir, Tyler, The Cost of Capital of the Financial Sector (December 21, 2015). Available at SSRN: https://ssrn.com/abstract=2706614 or http://dx.doi.org/10.2139/ssrn.2706614

Tobias Adrian

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

HOME PAGE: http://www.tobiasadrian.com

Evan Friedman

Columbia University ( email )

420 W. 118th Street
New York, NY 10027
United States

Tyler Muir (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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