An Empirical Asset Pricing Model Accommodating the Sector-Heterogeneity of Risk

Stock returns are generally difficult to explain, as they are comprised of many discrete channels of risk. Empirical asset pricing models (EAPM), such as the Fama-French five-factor model (FF5), have been used to partition these channels across a series of systematic risk factors, such as company si...

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Bibliographic Details
Published in:Atlantic economic journal 2019-12, Vol.47 (4), p.499-520
Main Author: Papenkov, Maksim
Format: Article
Language:English
Subjects:
Asset pricing
Averages
Best Undergraduate Paper Award Winner
Economics
Economics and Finance
Five factor model
Heterogeneity
International Economics
Investors
Macroeconomics/Monetary Economics//Financial Economics
Markets
Microeconomics
Partition
Power
Pricing policies
Profitability
Public Finance
Risk
Risk factors
Stocks
Subsets
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Summary:Stock returns are generally difficult to explain, as they are comprised of many discrete channels of risk. Empirical asset pricing models (EAPM), such as the Fama-French five-factor model (FF5), have been used to partition these channels across a series of systematic risk factors, such as company size (total market equity), value (book-to-market ratio), investment, and operating profitability. Prior EAPMs only accounted for how such factors contributed to risk at the market-level, ignoring any potential variation across sector. This study developed a sector-heterogenous model (SHM) which directly accounts for this variation by generalizing the Fama-French methodology to sector-subsets of stocks. The results demonstrated that risk is meaningfully heterogenous across sectors for each of the factors in the FF5, with different subgroups of factors being statistically significant within each sector. In a direct comparison of explanatory power, the SHM outperformed the FF5 and improved adjusted R 2 by an average of 5% for stocks across all sectors. Several applications of sector-heterogeneity were then demonstrated for stock-picking purposes, including a high-beta portfolio strategy using the SHM-beta which outperformed the S&P 500 in backtesting. This study concludes that meaningful sector-heterogeneity exists in market risk. This information is materially useful to investors.
ISSN:0197-4254
1573-9678
DOI:10.1007/s11293-019-09637-2