Abstract
In this paper, we investigate the relationship between common risk factors and average returns for Italian stocks. Our research has identified the Italian stock market's economic variables by using the results from factor analyses and time series regressions. We study several multi-factor models combining the relevant macroeconomic variables with the mimicking equity portfolios SMB (small minus big) and HML (high minus low) proposed by Fama and French (1993). The key question we want to ask ourselves, is whether the influential role of the size and book-to-market equity factors in explaining average stock returns can stand up well when competing with some macroeconomic factors. In other words, do stock returns carry some risk premium that is independent of either the market return or the economic forces that underlie the common variation in returns? Our empirical work estimates risk premiums using both traditional two-pass procedures and one-pass (full information) methodologies. We show that only the market index and variables linked to interest rate shifts are consistently priced in the Italian stock returns. The role of other factors, and in particular both the size and the price-to book ratio, are crucially dependent on the estimation procedure.