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Discussion Paper Details

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Title: The Cost of Capital of the Financial Sector

Author(s): Tobias Adrian, Evan Friedman and Tyler Muir

Publication Date: December 2015

Keyword(s): asset pricing, cost of capital and financial intermediation

Programme Area(s): Financial Economics

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.

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Bibliographic Reference

Adrian, T, Friedman, E and Muir, T. 2015. 'The Cost of Capital of the Financial Sector'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=11031