Estimating Beta

The values of alpha and beta produced by regression analysis are estimates of true alpha and beta that
exist for the security

The estimates are subject to error

So, as such they are not true values of alpha and beta

Alpha and beta are not stationary over time. Because the fundamental characteristics of the company
change

For Ex. Beta as a risk measure should be related to the capital structure of the firm and thus change as the
capital structure changes

Accuracy of the historical betas

Blume (1970, 1975) and Levy (1971) done some early work on this issue

Blume computed beta for non overlapping samples of 7 year periods i.e. 7/54- 6/61 and 7/61-6/68

Product Moment and Rank Order Correlation Coefficients of Betas

Betas of large portfolios are more correlated than small portfolios

Individual security beta contain less information about future beta

Why beta change?

Risk of the portfolio/security might change

1
Random error in estimation

Some beta increases and some other decrease. So grouped together it cancels out each other

Therefore less error in estimating portfolio beta

Adjusting historical beta

Can we improve the predictive ability of beta?

Let us assume,

1) True beta of all stocks is 1

But the estimates, some are 1, some are more than 1 and others are less than 1

2) Assume estimated beta above 1 is due to positive sampling error and less than 1 is due to negative
sampling error

But we do not have any reason to believe that positive sampling errors will be followed by positive
sampling error and negative by negative

If this scenario is correct, we should find, on an average beta converging towards to one in successive
periods

Measuring the tendency of beta to regress towards one- Blume’s Technique

Estimated Beta Coefficients for Portfolios of 100 Securities in Two Successive Periods

Since beta has tendency to move towards one, we need to modify the beta estimates to capture this

2
Blume (1975) calculated the beta for two periods i.e. 1948- 54 and 1955- 1961. Regress the beta of later
period against the beta of earlier period

Estimated regression is: β i 2=ai +b i β i 1

Measuring the Central Tendency of Beta Coefficients

If you want to forecast beta for period 1962- 68, substitute the betas of 1955- 1961 for β i 1 in the equation
and obtained β i 2 is the forecast for next period.

For example: If β i 1=2 adjusted beta is 1.69, if β i 1= 0.5 adjusted beta is 0.682 (For 0.343+0.677)

Since it relates betas over two periods, if beta increases over two periods it assumes that it will increase
for next period as well. Same is true for decline as well.

Unless there is a reason to suspect continuous drift, it is an undesirable property

Measuring the tendency of beta to regress towards one- Vasicek’s Technique

It is desirable not to adjust all betas by same magnitude.

Larger the sampling error, greater the adjustment and vice versa

Vasicek (1973) has proposed such a technique

2
Let β 1= Average beta across all stocks, σ β 1 = Variance of distribution of historical beta and

2
σ βi 1 =square of the standard error of the estimate of beta for security i at period 1

The weights add up to one and more uncertainty about the either estimate less is the weight placed on it.

So beta forecast for a security is

3
 2 2
σ βi 1 σ β1
β i 2= 2 2
β 1+ 2 2
βi 1
σ β 1 + σ βi1 σ β 1 +σ βi 1

It adjusts the observations with large standard errors further towards the mean than it adjusts observations
with small standard errors

The standard errors of the large beta stocks are larger than that of small beta stocks. So high beta stocks
will have their betas lowered by a larger percentage than small beta stocks will have their betas raised.

Accuracy of adjusted beta:

Klemkosky and Martin (1975) tested the accuracy of beta forecasts for two five year periods

In all cases both Blume and Vasicek techniques led more accurate forecasts than unadjusted beta

Vasicek method had a slight tendency to outperform the Blume technique

Beta as forecasters of correlation coefficients

Elton, Gruber and Urich (1978) tested the ability of following models to forecast the correlation structures

1. Historical Correlation matrix

2. Correlation matrix prepared by the estimating the betas from the prior period
3. Correlation matrix prepared by the estimating the betas from the prior two period and adjusted by
Blume technique
4. Correlation matrix prepared by the estimating the betas from the prior two period and adjusted by
Vasicek technique

Historical correlation matrix was the poorest of all techniques

In most cases it was outperformed by all beta estimates

But there was no clear superiority of any one over other techniques among the three. But in majority cases
adjusted betas were better forecasters than the unadjusted beta.

The Market Model

A less restrictive form single index model viz. market model found more usage in finance

4
Market model is identical to single index model except that there is no assumption that Cov(e iej)=0

Ri=α i + β i R m+ ei

Expected value for a stock is Ri=α i + β i R m

Reference:

1. Modern Portfolio Theory and Investment Analysis- Chapter 7-Correlation Structure of Security
Returns: Single Index Models (Elton, Gruber, Brown and Goetzmann- 7 th Ed)
2. Marshall E. Blume, “On the Assessment of Risk”, The Journal of Finance, Vol. 26, No. 1 (Mar.,
1971), pp. 1-10 (Available in Jstor)