Conditional Betas
54 Pages Posted: 16 Jan 2005
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Conditional Betas
Conditional Betas
Date Written: March 10, 2004
Abstract
Empirical evidence shows that conditional market betas vary substantially over time. Yet, little is known about the source of this variation, either theoretically or empirically. Within a general equilibrium model with multiple assets and a time varying aggregate equity premium, we show that conditional betas depend on (a) the level of the aggregate premium itself; (b) the level of the firm's expected dividend growth; and (c) the firm's fundamental risk, that is, the one pertaining to the covariation of the firm's cash-flows with the aggregate economy. Especially when fundamental risk (c) is strong, the model predicts that market betas should display a large time variation, that their cross-sectional dispersion should be pro-cyclical, and that investments in physical capital should be positively related to changes in betas. These predictions find considerable support in the data.
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