Journal of Financial and Quantitative Analysis

Research Article

Bayesian Analysis of Stochastic Betas

Gergana Jostovaa1 and Alexander Philipova2

a1 jostova@gwu.edu, George Washington University, Department of Finance, 2023 G St, Washington, DC 20052

a2 philipov@american.edu, American University, Kogod School of Business, Department of Finance, 4400 Massachusetts Ave, Washington, DC 20016.

Abstract

We propose a mean-reverting stochastic process for the market beta. In a simulation study, the proposed model generates significantly more precise beta estimates than GARCH betas, betas conditioned on aggregate or firm-level variables, and rolling regression betas, even when the true betas are generated based on these competing specifications. Our model significantly improves out-of-sample hedging effectiveness. In asset pricing tests, our model provides substantially stronger support for the conditional CAPM relative to competing beta models and helps resolve asset pricing anomalies such as the size, book-to-market, and idiosyncratic volatility effects in the cross section of stock returns.

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