Three Factors, Interest Rate Differentials and Stock Groups

MOTIVATED BY THE single period capital asset pricing model (e.g. Sharpe [33]), for years research centered on the use of a single factor model where the single factor represented the return on the market portfolio. Subsequently, multifactor models were derived in a generalized CAPM setting by Sharpe [34], Long [23], Merton [25] etc., as well as in the arbitrage pricing theoretic framework by Ross [30], [31]. Merton [25] in the context of continuous time intertemporal asset pricing derives what we might call a two-factor model where the additional factor is a portfolio which is perfectly negatively correlated with changes in the risk free rate. The general intertemporal asset pricing models developed by Long [23] or more recently by Cox, Ingersoll and Ross [5] can also be interpreted as multifactor models. On the empirical side numerous studies were finding systematic ex post dependence in the residuals from single factor models (e.g., Agmon and Lessard [1], Arnott [2], Basu [4], Estep [7], Farrell [8, 9], Levy [20], Rosenberg and