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.
|Journal||The Review of Financial Studies|
|Publication status||Published - Apr 2016|
- Asset Pricing
- Portfolio Construction
- Time-varying betas
- Panel Data
Cosemans, M., Frehen, R., Schotman, P., & Bauer, R. (2016). Estimating security betas using prior information based on firm fundamentals. The Review of Financial Studies, 29(4), 1072-1112. http://rfs.oxfordjournals.org/content/early/2016/01/30/rfs.hhv131.full?sid=18d93800-48ec-442e-aeba-fdbd6116e421