We propose a hybrid approach for estimating beta that shrinks rolling window estimates toward firm-specific priors motivated by economic theory. Our method yields superior forecasts of beta that have important practical implications. First, unlike standard rolling window betas, hybrid betas carry a significant price of risk in the cross-section even after controlling for characteristics. Second, the hybrid approach offers statistically and economically significant out-of-sample benefits for investors who use factor models to construct optimal portfolios. We show that the hybrid estimator outperforms existing estimators because shrinkage toward a fundamentals-based prior is effective in reducing measurement noise in extreme beta estimates.
- g12 - "Asset Pricing; Trading volume; Bond Interest Rates"
- g14 - "Information and Market Efficiency; Event Studies"
- EXPECTED STOCK RETURNS
- ASSET PRICING MODEL
- CONDITIONAL CAPM
Cosemans, M., Frehen, R., Schotman, P., & Bauer, R. (2016). Estimating Security Betas Using Prior Information Based on Firm Fundamentals. Review of Financial Studies, 29(4), 1072-1112. https://doi.org/10.1093/rfs/hhv131