Accounting for the Accuracy of Beta Estimates in CAPM Tests on Assets with Time-Varying Risks
Posted: 22 Oct 1998
This paper advocates two ways to make more efficient use of available information in reducing the bias of the risk premium estimate in two-pass tests of the CAPM. First, explicit modeling of the time-variability of betas can improve the accuracy of the beta forecasts. Second, the cross-sectional information available can be exploited more efficiently using individual stocks instead of portfolios provided that noisy beta predictions are given a smaller weight than more accurate ones. This paper proposes an adjustment of the cross-sectional regressions of excess returns against betas to give larger weights to more reliable beta forecasts. A significant positive relationship between returns and the beta forecast is obtained when the proposed approach is applied to data from the Helsinki Stock Exchange, while the traditional Fama-MacBeth (1973) approach as such finds no relationship at all.
JEL Classification: G12, G15
Suggested Citation: Suggested Citation