Common Risk Factors in Explaining Canadian Equity Returns

This paper adopts the Fama and French (1993) methodology for determining the common risk factors in the returns of Canadian stocks. Our results suggest that the three stock market factors, the excess stock market returns, a size factor, and a book-to-market equity factor, explain most of the variation in Canadian equity returns over time. Unlike in the U.S. equity market, the addition of bond market variables provides little explanatory power in the Canadian equity market, suggesting that the underlying factors influencing stocks and bonds are more distinct in Canada. The stock and bond market factors are then used to estimate the required returns on a sample of Canadian utilities separated into telco, gas/electric and pipeline portfolios. The results presented in this paper suggest that the Fama and French model can make an important contribution to cost of capital determination in regulatory proceedings, especially when combined with estimates based upon alternative methodologies, to provide the regulator with additional insight in deciding the allowed return.