Leverage, Beta Estimation, and the Size Effect

46 Pages Posted: 3 Aug 2014

See all articles by Wolfgang Drobetz

Wolfgang Drobetz

University of Hamburg

Iwan Meier

HEC Montreal - Department of Finance

Jörg Seidel

University of Hamburg - Faculty of Economics and Business Administration, Chair of Corporate and Ship Finance

Date Written: August 2, 2014

Abstract

A measurement error in beta that arises from changes in leverage during the beta estimation window contributes in explaining the size effect. Simulations of asset returns show that the magnitude of the bias in equity returns is proportional to the stock market-induced changes in leverage. We propose a point-in-time beta that incorporates leverage at the end of the beta estimation window rather than the average leverage during this window. Using the point-in-time beta to compute expected stock returns for historical U.S. data, we document that the size effect is substantially reduced. In contrast to other explanations of the size effect, our approach does not introduce market frictions or additional risk factors.

Keywords: Size effect, capital asset pricing model, leverage, estimation

JEL Classification: G12, G14

Suggested Citation

Drobetz, Wolfgang and Meier, Iwan and Seidel, Jörg, Leverage, Beta Estimation, and the Size Effect (August 2, 2014). Available at SSRN: https://ssrn.com/abstract=2475277 or http://dx.doi.org/10.2139/ssrn.2475277

Wolfgang Drobetz (Contact Author)

University of Hamburg ( email )

Moorweidenstrasse 18
Hamburg, 20148
Germany

Iwan Meier

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7 H2J 2K9
Canada
(514) 340-3198 (Phone)

Jörg Seidel

University of Hamburg - Faculty of Economics and Business Administration, Chair of Corporate and Ship Finance

Von-Melle-Park 5
Hamburg, 20146
Germany

HOME PAGE: http://www.iff-uhh.de/en/team/usf/joerg-seidel.html

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