Although the Fama and French’s three factor model is now the most popular replacement for CAPM in corporate finance and investment management,... Show moreAlthough the Fama and French’s three factor model is now the most popular replacement for CAPM in corporate finance and investment management, the exclusion of financial firms can be questioned on both theoretical and empirical grounds. Financial firms are around 19 percent of the value of the U.S. stock market. The financial service industry is the major industry in many large U.S. cities including New York, Chicago, Los Angeles and Miami in that their GDPs of financial services for each city are more than 23 percent. Also, there is no theoretical reason for excluding financial firms. Modigliani and Miller [31] [32] suggest that leverage affects beta, but it does not invalidate the capital asset pricing model. It would therefore be more satisfying if the pricing model applied generally, rather than being restricted to nonfinancial corporations. From this consideration, this paper assesses the validity of size and value risk as common risk factors to measure of expected equity returns in financial companies based on the fact that Fama and French [11] [12] excluded financial firms in their study of the cross-section of expected stock returns. The findings from empirical asset pricing tests suggest that size and value risk premia commonly exist in both nonfinancial and financial firms even if two factors are less explicable in financial firms, that an interest rate risk premium (ΔL/L) which defined as a financial firm specific risk factor only appears in financial companies. PH.D in Management Science, December 2012 Show less
