Extra-Market Components of Covariance in Security Returns

This study is concerned with the multiple-factor model of security returns, with its implications for a single-factor, market-index model applied to the same securities, and with statistical methods of estimating the parameters of a multiple-factor model and thereby operationalizing it. This part of the paper sets out the approach. The sequel will present the empirical results. The results show that there are highly significant extra-market components of covariance among security returns; moreover, these risk components are such that the loadings of individual security returns on the factors are determined by observable characteristics of the firm: income statement and balance sheet data, industry membership, and historical behavior of returns on the security. The results also show that the conventional security beta is a function of these same characteristics.