|Publication||Leverage, beta estimation, and the size effect|
University of Hamburg
Corporate Finance, Asset Pricing
Size effect, capital asset pricing model, capital structure, beta estimation
A measurement error in beta that arises from changes in leverage during the beta estimation window contributes in explaining the size effect. Simulations of asset returns show that the magnitude of the bias in equity returns is proportional to the stock market-induced changes in leverage. We propose a point-in-time beta that incorporates leverage at the end of the beta estimation window rather than the average leverage during this window. Using the point-in-time beta to compute expected stock returns for historical U.S. data, we document that the size effect is substantially reduced. In contrast to other explanations of the size effect, our approach does not introduce market frictions or additional risk factors.