Report

The cost of capital of the financial sector

Abstract: 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.

Keywords: asset pricing; cost of capital; capital structure; financial intermediation;

JEL Classification: G24; G12; G32; G21;

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2015-12-01

Number: 755

Pages: 52 pages