Beta Risk in the Cross-Section of Equities

Abstract

We develop a continuous-time intertemporal CAPM model that allows for risky beta exposure, which we explicitly specify. In the model, the expected return on a stock depends on beta's co-movement with market variance and more generally with the stochastic discount factor and deviates from the standard security market line when beta risk is priced. When estimating the model on returns and options we find that allowing for beta risk helps explain the expected returns on the low and high beta stocks, which are challenging for standard factor models.

Keywords: Factor models; stochastic beta; option-implied beta; Wishart processes

JEL Classification: G10; G12; G13