Estimating Security Betas Using Prior Information Based on Firm Fundamentals

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.

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article Effcient Estimation of Firm-Specific Betas and its Benefits for Asset Pricing Tests and Portfolio Choice M.M.J.E. Cosemans (Mathijs), R. Frehen (Rik), P.C. Schotman (Peter) and R. Bauer (Rob)