Estimating Security Betas Using Prior Information Based on Firm Fundamentals

Mathijs Cosemans, RGP Frehen, PC Schotman, RMMJ Bauer

Research output: Contribution to journalArticleAcademicpeer-review

24 Citations (Scopus)

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.
Original languageEnglish
Pages (from-to)1072-1112
Number of pages41
JournalThe Review of Financial Studies
Volume29
Issue number4
DOIs
Publication statusPublished - 2016

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