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Estimating security betas using prior information based on firm fundamentals
Cosemans,Mathijs Frehen,Rik Schotman,Peter Bauer,Rob
Cosemans,Mathijs
Frehen,Rik
Schotman,Peter
Bauer,Rob
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.
Description
Date
2016-04
Journal Title
Journal ISSN
Volume Title
Publisher
Research Projects
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Journal Issue
Keywords
Asset Pricing, Portfolio Construction, Time-varying betas, Shrinkage, Panel Data, G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates, G14 - Information and Market Efficiency ; Event Studies ; Insider Trading
Citation
Cosemans, M, Frehen, R, Schotman, P & Bauer, R 2016, 'Estimating security betas using prior information based on firm fundamentals', Review of Financial Studies, vol. 29, no. 4, pp. 1072-1112. < http://rfs.oxfordjournals.org/content/early/2016/01/30/rfs.hhv131.full?sid=18d93800-48ec-442e-aeba-fdbd6116e421 >