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



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.