Constructing Asset Pricing Models with Specific Factor Loadings

Abstract

We demonstrate how one can build pricing formulae in which factors other than beta may be viewed as determinants of asset returns. This is important conceptually as it demonstrates how the additional factors can compensate for a market portfolio proxy that is mis-specified, and also shows how such a pricing model can be specified ex ante. The procedure is implemented by first selecting an ‘orthogonal’ portfolio which falls on the mean-variance efficient frontier computed from the empirical average returns, variances and covariances on the equity securities of a large sample of firms. One then determines the inefficient index portfolio which leads to a vector of betas that when multiplied by the average return on the orthogonal portfolio, and which when subtracted from the vector of average returns for the firms comprising the sample, yields an error vector that is equal to the vector of numerical values for the variables that are to form the basis of the asset pricing formula. There will then be a perfect linear relationship between the vector of average returns for the firms comprising the sample, the vector of betas based on the inefficient index portfolio and such other factors that are deemed to be important in the asset pricing process. We illustrate computational procedures using a numerical example based on the quality of information contained in published corporate financial statements.