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On tests of the conditional relationship between beta and returns

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  • Ian Cooper

Abstract

The Pettengill et al. (1995) test of the conditional relationship between beta and returns has recently become widely used. This article shows that there is a large bias in that test. The test is almost guaranteed to be satisfied, regardless of the model that generates expected returns. In particular, even if the Capital Asset Pricing Model (CAPM) is not true and expected returns and beta are unrelated, the test will detect statistically significant results of the size that they report in line with their hypothesis. The reason for the bias is that the ex post selection criterion used to partition data automatically generates coefficient values that the test interprets as being evidence in favour of the CAPM.

Suggested Citation

  • Ian Cooper, 2009. "On tests of the conditional relationship between beta and returns," Applied Financial Economics, Taylor & Francis Journals, vol. 19(6), pages 427-432.
    • Handle: RePEc:taf:apfiec:v:19:y:2009:i:6:p:427-432
    DOI: 10.1080/09603100801964388
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    Cited by:

    1. Bartram, Söhnke M. & Bodnar, Gordon M., 2012. "Crossing the lines: The conditional relation between exchange rate exposure and stock returns in emerging and developed markets," Journal of International Money and Finance, Elsevier, vol. 31(4), pages 766-792.
    2. Durand, Robert B. & Lan, Yihui & Ng, Andrew, 2011. "Conditional beta: Evidence from Asian emerging markets," Global Finance Journal, Elsevier, vol. 22(2), pages 130-153.
    3. Guermat, Cherif & Freeman, Mark C., 2010. "A net beta test of asset pricing models," International Review of Financial Analysis, Elsevier, vol. 19(1), pages 1-9, January.
    4. Pankaj Agrrawal & Faye W. Gilbert & Jason Harkins, 2022. "Time Dependence of CAPM Betas on the Choice of Interval Frequency and Return Timeframes: Is There an Optimum?," JRFM, MDPI, vol. 15(11), pages 1-18, November.

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