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 statistical ly 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 cons tant traditional beta model. In this paper we show that this is indeed the case, namely that pricing errors with constant traditional beta m odels are smaller than with conditional CAPMs.