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Challenges in Estimation of Beta: Market Models Used for Risk Estimation
Abstract
Capital asset pricing model (CAPM) brings deep intuitive understanding of the relationship between expected return and risk. Unfortunately, the empirical record of the CAPM has not been satisfactory since its commencement. The empirical testing of CAPM is void in most cases due to the use of an inefficient index as a proxy for market portfolio. Plausible tests require a well-diversified market portfolio which so far has been unfeasible to obtain. Lack of validity in empirical records has been caused by complexity in exerting valid estimations of the beta coefficient. This chapter judges which of the indices provides investors the best beta forecast and questions which time period should be selected for beta calculation. This chapter reveals that the choice of return intervals causes variations in beta estimation of the security. Applying higher frequency has an advantage in that it increases the number of observations, but a shortfall is that beta tends to have substantial bias with shorter return intervals used.
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