<p>This is a partial answer (see section 5.1, p. 79 of Cochrane's book, "Asset Pricing"). Suppose you wanted to treat the size of the firm as a factor. Stocks of smaller firms typically have higher average returns. You could then form a "large" holding company comprised of smaller firms. The new, large company would then have returns like a smaller company but would in fact be large and "the managers could enjoy the difference."</p>

<blockquote>
  <p>What ruins this promising idea? The "large" holding company will still <em>behave</em> like a portfolio of small stocks---it will have their high betas. Thus, only if asset returns depend on <em>how you behave</em>, not <em>who you are</em>---on betas rather than characteristics---can a market equilibrium survive such simple repackaging schemes.</p>
</blockquote>

<p>(How would I formalize this concept?)</p>

<p>EDIT: Also, in Financial Asset Pricing Theory by Munk (chapter 10, p.371) it says</p>

<blockquote>
  <p>It is worth emphasizing that the general theoretical results of the consumption-based asset pricing framework are not challenged by factor models. ... Factor models do not invalidate the consumption-based asset pricing framework but are special cases that may be easier to apply and test. <em>Therefore factors should generally help explain typical indiviudals' marginal utilities of consumption.</em></p>
</blockquote>

<p>(Emphasis added) This helps to understand the role of factors in the ICAPM.</p>

CC BY-SA 3.0
2014-11-19T21:24:34.243Z
2014-11-25T21:33:55.423Z
2014-11-25T21:33:55.423Z
jmbejara
<p>This question is related to another question <a href="https://economics.stackexchange.com/questions/107/examples-of-factors-in-the-icapm">here</a>. The question linked to asks for examples of factors commonly used in ICAPM models (intertemporal capital asset pricing model). What I want to know here is this: what is underlying principle that makes a factor a valid factor in factor models such as the CAPM, ICAPM, or APT?</p>

<finance><asset-pricing>
What makes a factor valid in a factor pricing model of assets?
jmbejara
# What makes a factor valid in a factor pricing model of assets?

(Asked by: username_0 on 2014-11-19)

This question is related to another question [here](https://economics.stackexchange.com/questions/107/examples-of-factors-in-the-icapm). The question linked to asks for examples of factors commonly used in ICAPM models (intertemporal capital asset pricing model). What I want to know here is this: what is underlying principle that makes a factor a valid factor in factor models such as the CAPM, ICAPM, or APT?

**Tags:** finance, asset-pricing


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## 1 answers

### Answer by username_0 on 2014-11-19. Score: 1

This is a partial answer (see section 5.1, p. 79 of Cochrane's book, "Asset Pricing"). Suppose you wanted to treat the size of the firm as a factor. Stocks of smaller firms typically have higher average returns. You could then form a "large" holding company comprised of smaller firms. The new, large company would then have returns like a smaller company but would in fact be large and "the managers could enjoy the difference."

> What ruins this promising idea? The "large" holding company will still *behave* like a portfolio of small stocks---it will have their high betas. Thus, only if asset returns depend on *how you behave*, not *who you are*---on betas rather than characteristics---can a market equilibrium survive such simple repackaging schemes.

(How would I formalize this concept?)

EDIT: Also, in Financial Asset Pricing Theory by Munk (chapter 10, p.371) it says

> It is worth emphasizing that the general theoretical results of the consumption-based asset pricing framework are not challenged by factor models. ... Factor models do not invalidate the consumption-based asset pricing framework but are special cases that may be easier to apply and test. *Therefore factors should generally help explain typical indiviudals' marginal utilities of consumption.*

(Emphasis added) This helps to understand the role of factors in the ICAPM.


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