A Five-Factor Asset Pricing Model with Enhanced Factors

54 Pages Posted: 25 Jan 2023

See all articles by Manuel Ammann

Manuel Ammann

University of St. Gallen - School of Finance

Tobias Hemauer

University of St. Gallen - School of Finance

Simon Straumann

WHU - Otto Beisheim School of Management

Date Written: January 23, 2023

Abstract

A simple manipulation of the dividend discount model establishes that firms' book-to-market, profitability, and investment are related to their expected returns. This insight motivates the value, profitability, and investment factors in the Fama-French (2015) five-factor model. Yet, variation in book-to-market, profitability, or investment stems not only from differences in expected returns. In this study, we narrow down the variation in these variables that is actually informative about expected returns to construct enhanced versions of the value, profitability, and investment factors. Our enhanced factors exhibit considerably higher Sharpe ratios than the standard factors. Importantly, a five-factor model using our enhanced factors exhibits a much better pricing performance and generates a more upward sloping multivariate security market line than the standard five-factor model. Moreover, we show that our approach either complements or outperforms other recently proposed approaches to improve the Fama-French (2015) factors.

Keywords: Fama-French five-factor model, value factor, profitability factor, investment factor, cash flow shocks

JEL Classification: G12, G14

Suggested Citation

Ammann, Manuel and Hemauer, Tobias and Straumann, Simon, A Five-Factor Asset Pricing Model with Enhanced Factors (January 23, 2023). Available at SSRN: https://ssrn.com/abstract=4336292 or http://dx.doi.org/10.2139/ssrn.4336292

Manuel Ammann

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Tobias Hemauer (Contact Author)

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St. Gallen, 9000
Switzerland

Simon Straumann

WHU - Otto Beisheim School of Management ( email )

Burgplatz 2
Vallendar, 56179
Germany

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