Article1974

Extra-Market Components of Covariance in Security Returns

295 citations0/0 files storedJournal of Financial and Quantitative Analysis

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Financial Markets and Investment Strategies Financial Analysis and Corporate Governance Financial Risk and Volatility Modeling

Abstract

This study is concerned with the multiple-factor model of security returns, with its implications for a single-factor, market-index model applied to the same securities, and with statistical methods of estimating the parameters of a multiple-factor model and thereby operationalizing it. This part of the paper sets out the approach. The sequel will present the empirical results. The results show that there are highly significant extra-market components of covariance among security returns; moreover, these risk components are such that the loadings of individual security returns on the factors are determined by observable characteristics of the firm: income statement and balance sheet data, industry membership, and historical behavior of returns on the security. The results also show that the conventional security beta is a function of these same characteristics.

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1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1972Portfolio Theory and Capital Markets.1966Market and Industry Factors in Stock Price Behavior

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