Fixed Income Asset Pricing: Extending the Elton et al. (1995) Four-Factor Model

Abstract

This paper is enhancing the four-factor fixed income asset pricing model initially developed by Elton et al. (1995). The aim is to increase the explanatory power of the model in time series analysis. Vast progress has been made on equity asset pricing models since the introduction of the Capital Asset Pricing Model in the 1960s with the introduction of the Fama and French (1993) three-factor model and the Carhart (1997) four-factor model. Progress into fixed income asset pricing has been slow, and there is still no consensus of which combinations of bond indexes are most suitable for explaining the returns of fixed income securities and bonds. This paper shows that by introducing a duration factor, a global bond factor, and three exchange rate factors, the resulting ninefactor model can explain up to 95.42% of return variations in fixed income fund portfolios and up to 99.97% of the return variations of individual fixed income funds. The model is shown to be robust when using a global and regional benchmark specifications, and when used in the analysis of a wide range of fund strategies, fund types, and fund objectives.