Estimating Security Betas Using Prior Information Based on Firm Fundamentals

Review of Financial Studies, Forthcoming

AFA 2010 Atlanta Meetings Paper

WFA 2009 San Diego Meetings Paper

EFA 2009 Bergen Meetings Paper

60 Pages Posted: 13 Feb 2009 Last revised: 25 Feb 2017

See all articles by Mathijs Cosemans

Mathijs Cosemans

Erasmus University - Rotterdam School of Management

Rik Frehen

Tilburg University - Department of Finance

Peter C. Schotman

Maastricht University - Department of Finance

Rob Bauer

Maastricht University

Date Written: September 27, 2015

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.

Keywords: asset pricing, portfolio construction, time-varying betas, shrinkage, panel data

JEL Classification: G12, G14

Suggested Citation

Cosemans, Mathijs and Frehen, Rik and Schotman, Peter C. and Bauer, Rob, Estimating Security Betas Using Prior Information Based on Firm Fundamentals (September 27, 2015). AFA 2010 Atlanta Meetings Paper; Review of Financial Studies, Forthcoming; AFA 2010 Atlanta Meetings Paper; WFA 2009 San Diego Meetings Paper; EFA 2009 Bergen Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1342326 or http://dx.doi.org/10.2139/ssrn.1342326

Mathijs Cosemans (Contact Author)

Erasmus University - Rotterdam School of Management ( email )

Burgemeester Oudlaan 50
Rotterdam
Netherlands
+31104082371 (Phone)
+31104089017 (Fax)

HOME PAGE: http://www.mathijscosemans.com

Rik Frehen

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, DC 5000 LE
Netherlands

Peter C. Schotman

Maastricht University - Department of Finance ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands
+31 43 388 3862 (Phone)
+31 43 388 4875 (Fax)

Rob Bauer

Maastricht University ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands
+31 43 3883871 (Phone)

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