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Explanations for the Instability of Equity Beta: Risk-Free Rate Changes and Leverage Effects

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  • DeJong, Douglas V.
  • Collins, Daniel W.

Abstract

This paper is an initial attempt to bridge the gap that presently exists between the theoretical and empirical literature on the instability of equity beta. We focus on two factors from the joint Option Pricing Model/Capital Asset Pricing Model framework—leverage and unexpected changes in the risk-free rate—which are hypothesized to influence the instability of equity beta across firms and over time. Using alternative variable parameter regression models, we find that highly leveraged firms exhibit greater equity beta instability than firms with lower leverage. Over time, equity betas exhibit greater instability during periods of large unexpected changes in the risk-free rate when compared to periods with small unexpected changes in the risk-free rate.

Suggested Citation

  • DeJong, Douglas V. & Collins, Daniel W., 1985. "Explanations for the Instability of Equity Beta: Risk-Free Rate Changes and Leverage Effects," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 20(1), pages 73-94, March.
    • Handle: RePEc:cup:jfinqa:v:20:y:1985:i:01:p:73-94_01
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    Cited by:

    1. Fredj Jawadi & Wael Louhichi & Abdoulkarim Idi Cheffou & Hachmi Ben Ameur, 2019. "Modeling time-varying beta in a sustainable stock market with a three-regime threshold GARCH model," Annals of Operations Research, Springer, vol. 281(1), pages 275-295, October.
    2. Galloway, Tina M. & Lee, Winson B. & Roden, Dianne M., 1997. "Banks' changing incentives and opportunities for risk taking," Journal of Banking & Finance, Elsevier, vol. 21(4), pages 509-527, April.
    3. Gwangheon Hong & Sudipto Sarkar, 2007. "Equity Systematic Risk (Beta) and Its Determinants," Contemporary Accounting Research, John Wiley & Sons, vol. 24(2), pages 423-466, June.
    4. Ryan Stever, 2007. "Bank size, credit and the sources of bank market risk," BIS Working Papers 238, Bank for International Settlements.
    5. Sebastien Valeyre & Sofiane Aboura & Denis Grebenkov, 2019. "The Reactive Beta Model," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 42(1), pages 71-113, March.
    6. Sebastien Valeyre, 2020. "Refined model of the covariance/correlation matrix between securities," Papers 2001.08911, arXiv.org.
    7. Jonathan Ross, 2023. "Does prior stock return correlation predict future stock return correlation?," SN Business & Economics, Springer, vol. 3(9), pages 1-15, September.
    8. Sebastien Valeyre & Denis S. Grebenkov & Sofiane Aboura, 2019. "The Reactive Beta Model," Papers 1911.00919, arXiv.org.
    9. Faff, R. W. & Brooks, R. D. & Kee, Ho Yew, 2002. "New evidence on the impact of financial leverage on beta risk: A time-series approach," The North American Journal of Economics and Finance, Elsevier, vol. 13(1), pages 1-20, May.
    10. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.
    11. Carl Chiarella & Toan Pham & Ah Boon Sim & Madeleine Tan, 1991. "Determinants of Corporate Capital Structure: Australian Evidence," Working Paper Series 3, Finance Discipline Group, UTS Business School, University of Technology, Sydney.

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