DP11031 The Cost of Capital of the Financial Sector

Author(s): Tobias Adrian, Evan Friedman, Tyler Muir
Publication Date: December 2015
Keyword(s): asset pricing, cost of capital, financial intermediation
JEL(s): G12, G21, G24, G31
Programme Areas: Financial Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11031

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.