The risk factors that are rewarded in the market and thus determines the prices and expected returns on assets is a debated topic within the area of financial
economics. This study investigates which risk factors are rewarded in the Norwegian stock market. We will examine both macroeconomic factors and characteristic-based factors using prominent models such as the CAPM, the Fama-French three and five-factor models and a macroeconomic model. Moreover, we will compare which of the models is better in explaining expected returns.
The pioneering Capital Asset Pricing Model (CAPM) based on the work of Sharpe (1964), Lintner (1965) and Mossin (1966) established the foundation for modern financial theory. The CAPM is a single-factor model which describes a linear relation between the expected return on an asset and its covariance with the return on the market portfolio. Thus, the expected return for an asset increases as the exposure to the systematic risk inherent in the market portfolio increases.
Following the introduction of the CAPM, alternative asset pricing theories has developed, such as the Intertemporal CAPM (ICAPM) and the Arbitrage Pricing Theory (APT) introduced in Merton (1973) and Ross (1976), respectively. The ICAPM is a consumption-based asset pricing model, in which investors require compensation for changes in the investment opportunity set. Hence, state variables that influences the investment opportunity set are predicted to be
rewarded in the market. Further, the APT predicts that general news or shocks that affect returns on all assets through systematic risk should be priced, such as
macroeconomic variables.
In 1985, Chan, Chen and Hsiesh identified a set of macroeconomic variables and test whether these risks were rewarded in the US stock market. Their model included variables that a priori were expected to be priced such as changes in the term structure, growth in the industrial production, unexpected changes in inflation and bond spread. Their results support that unexpected changes in the inflation, the industrial production and the bond risk premium are significantly
similar variables, however by including the oil price risk and the aggregate consumption to examine whether these are priced as well. Chen et al. (1986) conclude that several of the macroeconomic variables are rewarded in the US market. Nevertheless, neither the consumption nor the oil price risk was found to be separately rewarded in the stock market, in similarity to the market portfolio.
Shanken and Weinstein (2006) suggest correcting the standard errors for
measurement errors, which consequently will decrease the statistical significance reported in Chan et al. (1985) and Chen et al. (1986). Further, they report a lack of robustness in the results, and suggest an alternative procedure in forming the portfolios. Applying these changes, Shanken and Weinstein (2006) finds evidence that only the industrial production is priced in the US market. Moreover,
Bodurtha, Cho and Senbet (1989) replicated and expanded the research of Chen et al. (1986) by considering international variables as well. In similarity to Shanken and Weinstein (2006), they find that only the industrial production is priced among the domestic variables. However, their findings indicate that the model is improved when including an international dimension. Recently, Benaković and Posedel (2010) examined whether macroeconomic factors are priced in the Croatian market and find a significant risk premium for the market and inflation.
Fama and French (1993) found that small company stocks tend to outperform large company stocks, and that value stocks tend to outperform growth stocks.
Creating two factor mimicking portfolios SMB and HML to capture these
anomalies, they extended the CAPM to a three-factor model (FF3). Thus, the FF3 explains the expected return on assets by combining a market factor, a size factor and a value factor. However, as researchers found that the FF3 fails to capture certain anomalies, alternative models were introduced. In particular, the FF3 did not capture the momentum effect as described in Jegadeesh and Titman (1993).
Therefore, Carhart (1997) extended the FF3 to a four-factor model by including a momentum factor UMD. In 2012, Hou, Zue and Zhang introduced the Q-factor model as an alternative to the FF3 and Carhart’s four-factor model. The Q-factor model includes a market factor, a size factor, an investment factor and a
profitability factor, and Hou, Zue and Zhang (2015) argue that the performance of the Q-factor is in many cases better than the FF3 and Carhart’s four-factor model.
More recently, Fama and French (2015) extended their FF3 by including two
additional factor portfolios for profitability (RMW) and investment (CMA), though with changes in the definitions of the profitability and investment factors from those of Hou et al. (2012). Further, Fama and French (2015) shows that the FF5 perform better in explaining expected returns than the FF3, however with an insignificant value (HML) factor.
Hence, a fundamental question in financial economics concerns which risks are rewarded in the stock market. There are competing asset pricing theories and empirical models that seek to help in identifying the priced risks, thus assist in understanding the risk-return relationship and pricing of financial assets. The conspicuous discrepancy is the motivation for this study. Therefore, we will identify which risk factors are priced in the Norwegian stock market and further which model is superior, based on several theories and empirical models. This will consequently enable investors to make better investment decisions.
In order to investigate which factors are priced in the Norwegian stock market and which of the models performs the best in our sample period, we identify
macroeconomic and characteristic-based factors that are expected to be priced.
Moreover, we identify four different models to test: the CAPM, the FF3, the FF5 and a macroeconomic model. We will estimate the models using the Fama-MacBeth (1973) procedure, as this allows us to examine the coefficients and statistical significance of risk premia estimates corrected for cross-sectional correlation. We will analyze the results obtained to examine which factors are priced and further compare the models based on their estimated intercepts, goodness of fit statistics and the stability in results in a robustness analysis.
We emphasize that our contributions to the field of finance are: i) constructing the factor portfolios RMW and CMA as described in Fama and French (2015) for the Norwegian stock market in our sample period and ii) identifying whether a macroeconomic model or a characteristic-based model is best in explaining the expected returns in the Norwegian stock market in our sample period.
The rest of this study is organized as follows. The second section comprise theories and empirical studies related to asset pricing models. In the third section,
we present the models and factors we will examine. In the fourth section, we clarify the methodology we use in estimating the models and comparing them.
Further, in the fifth section we describe the data used in the study. The sixth section contains the empirical results for the estimated models and a discussion part, in which the models are compared. In the seventh section we present our conclusion of the study based on our analysis of the obtained results.