Time-Varying Beta: A Boundedly Rational Equilibrium Approach

Abstract

By taking into account conditional expectations and the dependence of the systematic risk of asset returns on micro- and macro-economic factors, the conditional CAPM with time-varying betas displays superiority in explaining the cross-section of returns and anomalies in a number of empirical studies. Most of the literature on time-varying beta is motivated by econometric estimation rather than explicit modelling of the stochastic behaviour of betas through agents' behaviour. Within the mean-variance framework of repeated one-period optimisation, we set up a boundedly rational dynamic equilibrium model of a financial market with heterogeneous agents and obtain an explicit dynamic CAPM relation between the expectede quilibrium returns and time-varying betas. By incorporating the three most popular types of investors, fundamentalists, chartists and noise traders, into the model, we show that, independent of the fundamentals, there is a systematic change in the market portfolio, risk-return relationships, and time varying betas when investors change their behaviour, such as the chartists acting as momentum traders. In particular, we demonstrate the stochastic nature of time-varying betas and show that the commonly used rolling window estimates of time-varying betas may not be consistent with the ex-ante betas implied by the equilibrium model. The results provide a number of insights into an understanding o ftime-varying beta.equilibrium asset prices; CAPM; time-varying betas, heterogeneous expectations