We improve both the specification and estimation of firm-specific betas. Time variation in betas is modeled by combining a parametric specification based on economic theory with a non-parametric approach based on data-driven filters. We increase the precision of individual beta estimates by setting up a hierarchical Bayesian panel data model that imposes a common structure on parameters. We show that these accurate beta estimates lead to a large increase in the cross-sectional explanatory power of the conditional CAPM. Using the betas to forecast the covariance matrix of returns also results in a significant improvement in the out-of-sample performance of minimum variance portfolios.

Additional Metadata
Keywords asset pricing, portfolio choice, time-varying betas, Bayesian econometrics, panel data
JEL Bayesian Analysis (jel C11), Models with Panel Data (jel C33), Asset Pricing (jel G12)
Persistent URL hdl.handle.net/1765/93505
Note An earlier draft of this paper was titled "A Bayesian Panel Data Approach to Explaining Market Beta Dynamics".
Cosemans, M.M.J.E, Frehen, R, Schotman, P.C, & Bauer, R. (2009). Effcient Estimation of Firm-Specific Betas and its Benefits for Asset Pricing Tests and Portfolio Choice. Retrieved from http://hdl.handle.net/1765/93505