On Stable Factor Structures in the Pricing of Risk: Do Time-Varying Betas Help or Hurt?


  • Eric Ghysels

    1. Department of Economics, Pennsylvania State University and CIRANO
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    • *Department of Economics, Pennsylvania State University, and CIRANO. We would like to thank Wayne Ferson and Campbell Harvey for their invaluable help in providing their data. We are also most grateful to two referees and to the editor, René Stulz, for their very helpful comments. Benoit Durocher provided excellent research assistance. We would also like to thank Cliff Ball, Ravi Bansal, Wayne Ferson, René Garcia, Eric Jacquier Eric Renault, Pierre Séquier S. Viswanathan, and participants at the CREST—Compagnie Bancaire Conference, the 1995 Western Finance Association and American Finance Association Meetings, the Brazilian Econometric Society Meetings, HEC Paris, and Penn State for their comments.


There is now considerable evidence suggesting that estimated betas of unconditional capital asset pricing models (CAPMs) exhibit statistically significant time variation. Therefore, many have advocated the use of conditional CAPMs. If we succeed in capturing the dynamics of beta risk, we are sure to outperform constant beta models. However, if the beta risk is inherently misspecified, there is a real possibility that we commit serious pricing errors, potentially larger than with a constant traditional beta model. In this paper we show that this is indeed the case, namely that pricing errors with constant traditional beta models are smaller than with conditional CAPMs.