Review of Financial Studies Vol. 29 No. 4 2016
Estimating Security Betas Using Prior Information Based on Firm Fundamentals
Abstract
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.
- DOI
- 10.1093/rfs/hhv131
- Volume
- 29
- Issue
- 4
- Pages
- 1072-1112
- Language
- en
- Sources
- crossref openalex