Abstract

Does the Cycle Factor explain Returns on Equity?

In order to explain equity returns, the single index model (which corresponds to the CAPM) was extended in various ways to multi-factor models. Following Chen/Roll/Ross, macroeconomic variables are the favorites for the additional factors. Fama/French (1993–1998) use the return of specially constructed long-short portfolios as additional factors. These portfolios, SMB (small minus big), and HML (high minus low) may be interpreted to represent the macroeconomic situation and the business cycle.

Our work offers these results. First we calibrate the three factor model of Fama/French for Swiss data. This is rewarding, because there is no HML effect in Switzerland, if recent data is used. We offer a (theoretical) explanation. Second, we study, whether SMB and HML may be "aggregated„. For this purpose, we define a single factor which captures cyclical effects in the capital market. We compare the power of this cyclical factor using data for the US, and Switzerland, respectively. Furthermore, we compare two single factor models. One uses the forementioned cyclical factor and the respective exposure, the so-called cycle beta. The other uses the classical market risk.