Estimating Security Betas Using Prior Information Based on Firm Fundamentals

Mathijs Cosemans, Rik Frehen, Peter C. Schotman and Rob Bauer

The Review of Financial Studies, 2016, vol. 29, issue 4, 1072-1112

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. Received May 17, 2011; accepted October 7, 2015 by Editor Geert Bekaert.

Date: 2016
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