Beta Reversal and Expected Returns

59 Pages Posted: 15 Mar 2014

See all articles by Yexiao Xu

Yexiao Xu

University of Texas at Dallas - School of Management

Yihua Zhao

Tulane University - A.B. Freeman School of Business

Date Written: January 1, 2014


In this paper we show that the failure of the CAPM beta to predict individual stocks' expected returns documented by Fama and French (1992) is largely driven by a small group of stocks with large betas and high idiosyncratic volatilities. These stocks' betas tend to reverse. Therefore, even when the CAPM holds period-by-period, the cross-sectional evidence on market beta is weak at best due to the confounding effect of beta reversal and instability. We further show that such a beta reversal is partly predictable by idiosyncratic volatility. As a result, the current beta estimates of individual stocks can significantly explain the cross-sectional differences in future returns whit a simple control for such a reversal effect. In fact, the market risk premium estimated from cross-sectional regression is close to that of the historical average. All results are robust with respect to different measures of beta and idiosyncratic volatility as well as different subsamples. In addition, we explore several possible causes for the beta reversal phenomenon.

Keywords: Beta Instability, Beta Reversal, Expected Return, and Idiosyncratic Volatility

JEL Classification: G12

Suggested Citation

Xu, Yexiao and Zhao, Yihua, Beta Reversal and Expected Returns (January 1, 2014). Asian Finance Association (AsianFA) 2014 Conference Paper, Available at SSRN: or

Yexiao Xu (Contact Author)

University of Texas at Dallas - School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States
972-883-6703 (Phone)


Yihua Zhao

Tulane University - A.B. Freeman School of Business ( email )

7 McAlister Drive
New Orleans, LA 70118
United States

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