The Cost of Capital of the Financial Sector
57 Pages Posted: 22 Dec 2015 Last revised: 17 Dec 2016
Date Written: December 21, 2015
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.
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