The Cost of Capital of the Financial Sector

53 Pages Posted: 12 Jan 2016

See all articles by Tobias Adrian

Tobias Adrian

International Monetary Fund

Evan Friedman

Paris School of Economics

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

Keywords: asset pricing, cost of capital, financial intermediation

JEL Classification: G12, G21, G24, G31

Suggested Citation

Adrian, Tobias and Friedman, Evan and Muir, Tyler, The Cost of Capital of the Financial Sector (December 2015). CEPR Discussion Paper No. DP11031, Available at SSRN: https://ssrn.com/abstract=2714291

Tobias Adrian (Contact Author)

International Monetary Fund ( email )

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Evan Friedman

Paris School of Economics ( email )

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France

Tyler Muir

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

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Los Angeles, CA 90095-1481
United States

National Bureau of Economic Research (NBER) ( email )

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Cambridge, MA 02138
United States

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