Rationalizing Size, Value, and Momentum Effects with a CAPM2

Abstract

This paper shows that a Capital Asset Pricing Model based on Continuous Asymmetric Polynomial Models (CAPM2) can identify the sources of risk that drive the cross section of stock returns. In accordance with recent decision theory models, the CAPM2 can price the key factors that drive risky choice behavior: (i) Goal Achievement (importance of the overall probability of obtaining positive payoffs), (ii) Loss Aversion (losses loom larger than gains), and (iii) preference for Security/Potential (downside risk aversion and preference for upside potential). These three factors are also the key drivers of size, value, and momentum portfolio returns. Therefore, size, value, and momentum factors do not load when they are tested on the CAPM2. Moreover, zero cost portfolios that take long (short) positions on securities with the highest (lowest) loadings on the three CAPM2 factors deliver positive and statistically significant risk adjusted returns.