Estimating security betas using prior information based on firm fundamentals

Mathijs Cosemans, Rik Frehen, Peter Schotman, Rob Bauer

Research output: Contribution to journalArticleScientificpeer-review

15 Citations (Scopus)
173 Downloads (Pure)

Abstract

We propose a hybrid approach for estimating beta that shrinks rolling window estimates towards firm-specific priors motivated by economic theory. Our method yields superior forecasts of beta that have important practical implications. First, hybrid betas carry a significant price of risk in the cross-section even after controlling for characteristics, unlike standard rolling window betas. 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 towards a fundamentals-based prior is effective in reducing measurement noise in extreme beta estimates.
Original languageEnglish
Pages (from-to)1072-1112
JournalThe Review of Financial Studies
Volume29
Issue number4
Publication statusPublished - Apr 2016

Keywords

  • Asset Pricing
  • Portfolio Construction
  • Time-varying betas
  • Shrinkage
  • Panel Data

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