Columbia Business School; National Bureau of Economic Research (NBER)
University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
March 10, 2004
AFA 2005 Philadelphia Meetings Paper
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.
Number of Pages in PDF File: 54
Date posted: January 16, 2005