Modelling Sector-Level Asset Prices

Abstract

We present a modelling approach for sector asset pricing studies that incorporates sector-level risk factors, subgroup portfolios, and structural breakpoint tests that are better at isolating the time-varying nature and the firm-specific component of returns. Our results show considerable subsector heterogeneity, while the asset pricing model using local risk factors and inductive structural breaks results in a superior model ((Formula presented.) of 80.42% relative to (Formula presented.) of 68.79% of “conventional” models). Finally, we show that some of the variances of residuals, normally assumed to be the firm-specific component of returns, can be attributed to the changing relationship between sector returns and risk factors.