An alternative approach for investigating risk factors

University essay from Handelshögskolan i Stockholm/Institutionen för finansiell ekonomi

Abstract: Studying the five-factor asset pricing model developed by Eugene F. Fama and Kenneth R French in 2015, this paper finds conclusive evidence that the premium awarded to non-financial, American firms for exposure towards the newly added investment factor differs depending on firm characteristics. More specifically, a positive relationship is found between the investment risk premium and the asset turnover ratio, a component of the DuPont analysis measuring the asset use efficiency of a firm. Furthermore, the asset turnover ratio is found to be decreasing over time, indicating that the investment factor may become irrelevant when predicting cross-sectional variation in returns going forward. Lastly, an accidental finding proposes that the ratio should be tested as a potential variable for factor construction. The general asset pricing models have been extensively used by both the academic community as well as various capital market participants. Although being able to explain variation in returns for the overall market better than its predecessors, one should be careful when applying the model to predict returns for subgroups of firms. Therefore, this paper suggests moving the research on the subject in an alternative direction.

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