Tuesday, January 19, 2016

New York Fed: A Financial Firm Cost Of Capital Oddity

From the Social Science Research Network:
The Cost of Capital of the Financial Sector

Tobias Adrian

Federal Reserve Bank of New York

Evan Friedman

Columbia University

Tyler Muir

Yale University

December 1, 2015

FRB of NY Staff Report No. 755
Standard factor pricing models do not capture well the common time-series or cross-sectional variation in average returns of financial stocks. 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 compared with the Fama and French (2014) five-factor model or the Hou, Xue, and Zhang (2014) four-factor models. We find that the aggregate expected return to financial sector equities correlates 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.

Number of Pages in PDF File: 52