Equities - Macroeconomic factor models


Looking at that 5-factor BIRR model example on page 75, when considering “Sensitivity to confidence index” if the sensitivity is high then the Beta will be closer to one and thus increase this factor…

What I don’t understand is why this factor increases and thus increases the cost of equity, r. Since confidence index is a positive thing should we deduct this factor from the equation?

r = T-bill rate + (Sensitivity to confidence index x 2.59%)…


It can’t be negative because the spread between corporates and treasuries can’t be less than zero. If you’re 100% confident in your corporate bond, the sensitivity will be zero. A negative sensitivity would imply treasuries are risker than corporates!

I think i’m having trouble grasping the concept of:

Sensitivity to the spread between corporate bonds and gov’t bonds…

In this case sensitivity is analogous to volatility. When economy is doing better, volatility is low (but never zero). So this factor will be lower since spreads between coporates and treasuries is small.

When economy is in the shitter, spreads between treasuries and corporates increase because volatility increases (this is not always true, but generally is). So you can expect this factor to be higher.