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A five-factor asset pricing model with enhanced factors

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Author
Manuel Ammann Tobias Hemauer Simon Straumann
Category
Financial
Date Posted
2023/01/23
Date Retrieved
2023/01/24
Date Revised
Date Written
2023/01/23
Description
A simple manipulation of the dividend discount model establishes that firms book-to-market profitability and investment are related to their expected returns. This insight motivates the value profitability and investment factors in the Fama-French (2015) five-factor model. Yet variation in book-to-market profitability or investment stems not only from differences in expected returns. In this study we narrow down the variation in these variables that is actually informative about expected returns to construct enhanced versions of the value profitability and investment factors. Our enhanced factors exhibit considerably higher Sharpe ratios than the standard factors. Importantly a five-factor model using our enhanced factors exhibits a much better pricing performance and generates a more upward sloping multivariate security market line than the standard five-factor model. Moreover we show that our approach either complements or outperforms other recently proposed approaches to improve the
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JEL Classifications
G12 G14
Keywords
Fama-French five-factor model value factor profitability factor investment factor cash flow shocks
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54
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