Journal of Applied Statistics Vol. 36, No.

1, January 2009, 7989

A two-phase approach to estimating time-varying parameters in the capital asset pricing model
Yih Sua and Jing-Shiang Hwangb
a Department b Institute

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of International Business, Cheng Shiu University, Kaohsiung, Taiwan; of Statistical Science, Academia Sinica, Taipei, Taiwan

(Received 7 December 2007; nal version received 6 August 2008)

Following the development of the economy and the diversication of investment, mutual funds are a popular investment tool nowadays. Choosing excellent targets from hundreds of mutual funds has become more and more crucial to investors. The capital asset pricing model (CAPM) has been widely used in the capital cost estimation and performance evaluation of mutual funds. In this study, we propose a new two-phase approach to estimating the time-varying parameters of CAPM. We implemented a simulation study to evaluate the efciency of the proposed method and compared it with the commonly used state space and rolling regression methods. The results showed that the new method is more efcient in most scenarios. Meanwhile, the proposed approach is very practical and it is unnecessary to judge and adjust the estimating process for different situations. Finally, we applied the proposed method to equity mutual funds in the Taiwan stock market and reported the performances of two funds for demonstration. Keywords: CAPM; two-phase estimation; time-varying parameter

1.

Introduction

In recent years, the beta parameter of the capital asset pricing model (CAPM) has been playing a central role in modern nance as a measure of asset risk. Many approaches for examining the validity of CAPM have been proposed, see for example, [1,9,10]. Note that those methods all depend on the important assumption that the system risk parameter, beta, is constant. Generally speaking, the system risk parameter beta can be resolved by simply regressing an assets returns on the return to the market portfolio, and this method is called the market model. However, it is well known that asset returns may not be stationary in practice; and the parameter beta is instable over time. This fact has been conrmed by many empirical investigations in the literature such as [2,7,8,11,16]. The parameters which change over time are called time-varying parameters. Without additional information, it is difcult to estimate the time-varying parameters by cross-sectional
Corresponding

author. Email: suyih@csu.edu.tw

ISSN 0266-4763 print/ISSN 1360-0532 online 2009 Taylor & Francis DOI: 10.1080/02664760802443871 http://www.informaworld.com

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models because we usually obtain only one single set of data for each time point; moreover, another difculty about time-varying parameter estimation is that the variables are stochastic and unobservable. Many methods have been developed to solve the problem of estimating time-varying parameters. The state space is most widely used in the literature, e.g. [5,12]. Another simple method widely used for estimating time-varying parameters is the rolling regression model that is interpreted as the poor mans time-varying parameter model in Zivot and Wang [19]. It uses the k (window size) most recent observations from t k + 1 to t and least-squares method to estimate the tth time-varying parameters. It is clearly the length of window that rules the estimators of rolling regression. A short window often leads to large variation of estimates, but on the contrary, if the window is too long, the estimates may be too smooth and lose the characteristics of the variation of asset over time. Recently, there has been much in the literature concerned with estimating time-varying parameters or using time-varying parameters to model some special cases. Orbe et al. [18] proposed a new nonparametric method which is based on smoothers to estimate time-varying parameters under shape restrictions. Kim [15] provided a solution to the time-varying model with endogenous regressor. In general, we may assume that the CAPMs time-varying parameters change slowly over time. When facing changes in the economic environment, capital asset managers need some time to adjust and relocate the capital assets. Hence the time-varying parameter can be assumed to be a slowly changing smooth function of the time index. In this article, we follow the estimation method that is provided by Hwang and Chan [14] to propose a new two-phase estimation method to estimate the time-varying parameter. In the rst phase, we use the rolling regression model with small window sizes to estimate the time-varying parameters. Although short rolling window periods lead to a larger variation of the estimates, we still suggest using a relatively short window to catch the economic circumstances at the time. In the second phase, we use a nonparametric estimation method, smoothing splines, to modify the large variation and smooth the rst phase estimates. Much literature uses the cross-validation (CV) criterion or generalized cross-validation (GCV) criterion to select the smooth parameter, which dominate the degree of smoothness. However smoothing splines estimates derived by the CV or GCV criterion may still lack smoothness due to the high variations of the estimates produced in the rst phase. Therefore, we also provide a simple strategy to avoid the lack of smoothness and to ensure that the estimates of the second phase model do smooth the ordinary least-square estimates from the rst phase. We conduct a simulation study to evaluate the performance of our method and compare it with the state space and rolling regression methods. We nd out that our method is more efcient in most scenarios. Furthermore, our method is very practical and easy to use without subjective judgment and adjustment in the estimating process. Finally, to see how our new estimation method works in practical examples, we use the two-phase estimation method to re-estimate time-varying parameters and to evaluate the performance of equity mutual funds in the Taiwan stock market. The rest of the article is organized as follows. Section 2 presents the two-phase estimation method for CAPM time-varying parameters. Section 3 provides a simulation and empirical study. We compared the proposed two-phase method with the state space and rolling regression estimator by using the mean square error (MSE). Conclusions are made in the nal section. 2. Method

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The slowly changing property of parameters plays the most important role in time-varying models. We propose a new two-phase estimation method to solve the estimating problem of time-varying parameters. In the rst phase model, we estimate the time-varying parameter by the rolling regression model with a rolling window assumed to be 2k + 1 times. At time t, (t k), we use the assets excess return and excess return of the market portfolio from times t k to t + k as response and

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explanatory variables, respectively. It is necessary to emphasize that our rst phase model is different from the widely used rolling regression which adopts the observations from t 2k to t to estimate the time-varying parameter at time t. For distinguishing purposes, our model is called the symmetric rolling regression model (SRRM). The reason why we select SRRM instead of rolling regression is to avoid the estimate lags behind the real parameters. Moreover, SRRM can be expressed as rs = t + t rms + s , s = t k, . . . , t, . . . , t + k, where rs and rms are the excess return of an asset and market portfolio, respectively. The rolling least-squares estimates are denoted as t and t (t = k + 1, k + 2, . . . , T k), and called crude estimates. In order to reduce the trouble of choosing the window length, we suggest using a shorter window for keeping the characteristics of parameters. For the purpose of reducing the large variation of crude estimates due to small window sizes, we use the smoothing splines method as our second phase model. The smoothing splines estimate is dened as a candidate function f which minimizes the penalized residual sum of square (PRSS). The PRSS is
T
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PRSS(f, ) =
t=1

(yt f (xt ))2 +

a

[f (u)]2 du,

(1)

where (yt , xt ) are the observations, is a smoothing parameter and xt is within [a, b]. In Equation (1), the rst term of PRSS is the residual sum of squares, the second term is a penalty measure, and the parameter controls the trade-off between goodness-of-t and smoothness. Larger values produce smoother curves while smaller values produce more wiggly curves. The smootht ing parameter is chosen by the CV to minimize the CV score GCV() = (yt f (xt ))2 /T . t (xt ) is the smoothing spline calculated from all of the data except (yt , xt ) For observation yt , f using the value as the smoothing parameter. The GCV is proposed as an approximation of CV for linear tting under square-error loss. We can write Y = A Y , where Y = [y1 , y2 , . . . , yn ]t , and A is called a smoother matrix. The smooth parameter in the matrix is selected so that the GCV score GCV() = {(yt yt )/(1 tr(A )/n)}2 /T is minimized. More details about CV, GCV and computation can be found in Eubank [6] and Hastie et al. [13]. For the rst phase model in our estimation method, we use the ordinary least-square method to estimate the time-varying parameter each time. But the least-square method may make the smoothing splines estimate lose its smoothness when we use CV or GCV to decide the smoothing parameter in second phase. This problem can be solved by selecting the smoothing parameter manually, but it is difcult because of the shortage of the observation character or the difference of the researchers subjective judgment. With the assumed slowly changing property of the timevarying parameter, we propose borrowing strength from neighboring crude estimates at each time point. One simple way is to treat all the crude estimates at time points max(t h, 1), . . . , t 1, t, t + 1, . . . , min(t + h, T ) for some small integer h as estimates of the parameter at time t. It means that we inate the crude estimate to have 2h + 1 values for each time t = h + 1, . . . , T h. Including the neighboring crude estimates will allow us to overcome the lack of smoothness problem when we use CV or GCV to decide the smoothing parameter. In notation, we let t be the crude estimate of the time-varying parameter at time t, and we dene the inated data of symmetric h-nearest neighbors of t as Nh (t ) = {max(th,1) , . . . , t1 , t , t+1 , . . . , min(t+h,T ) }, h 1, t = 1, 2, . . . , T . For convenience, we re-index the sym metric h-nearest neighbors Nh (t ) = {t1 , t2 , . . . , tJ }, t = 1, 2, . . . , T , J = min(t + h, T ) max(t h, 1) + 1. The smoothing splines model can be written as
T J

PRSS(f, ) =
t=1 j =1

(tj f (t))2 +
a

[f (u)]2 du.

(2)

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The smoothing splines estimator in Equation (2) can attain smoothness through automatically choosing a smoothing parameter by the CV or GCV criterion. This also solves the problem of manually selecting the smoothing parameter. In summary, we estimate the CAPMs time-varying parameters in two phases. First, crude estimates are obtained by tting an SRRM with a small window size for capturing the characteristic of economic circumstances at the time. The smoothing splines method is then used in the second phase to reduce the variation of the crude estimates. A point to be stressed is that we also propose a symmetric nearest neighbors strategy to avoid roughness and the difculty of selecting a smooth parameter manually. 3. 3.1 Simulation and empirical study Simulation study

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In this section, we employ the simulation method to analyze the practical performance of the proposed two-phase approach. First of all, we draw 201 consecutively weekly observations from the TAIEX (Taiwan Stock Exchange Capitalization Weighted Stock Index) during years 2000 2005 and denote as It , t = 1, . . . , 201. Then we calculate the market returns rmt = 100(It+1 It /It ). Next, we generate the simulation data of the assets return by the following model: 0t = a0 + a1 sin 1t = b0 + b1 sin 2t 72 2t 72 + a2 cos + b2 cos 2t 104 2t 104 + 0t , 0t N 0,0.052 , + 1t , 1t N 0, 0.052 , (3)

rt = 0t + 1t rmt + t ,

t N 0, 2 , t = 1, . . . , 200.

In order to assign proper values for the parameters in the simulation model, we calculate the alpha and beta parameters of 20 weekly stock mutual funds in Taiwan from January 2000 to November 2006. The average alpha and beta parameters of 20 weekly equity mutual funds are 0.13 and 0.92, respectively. Therefore we assume a0 = 0.1 and b0 = 1, and choose a1 , b1 from small values 0.3, 0.5, 0.7 and 0.9 to mimic some characteristics of practical series. Besides, to decrease the complexity of the simulation, we take a2 = 0.3a1 and b2 = 0.5b1 . For understanding the performance of estimating methods, we generate 200 observations of the assets return and assume at least two market cycles in that sample period, which are a short market cycle of 72 time periods (about six quarters for weekly data) and a longer but smaller uctuation market cycle (104 time periods) in Equation (3). Moreover, we calculate the standard deviation of 20 stock mutual funds, and nd that standard deviation ranges between 2.88 and 4.38. For further understanding the inuence of standard deviation, we therefore choose = 2, 3, 4, 5. For the sake of making simulation data to close practical series, two random terms 0t , 1t are added in. Considering that the time-varying parameters change slowly over time, we assume the variation range of the parameters is 0.2; so standard deviation is chosen as 0.05 for the two random terms. For each case, 100 sets of data are generated by Equation (3). For each set of simulated data, we use the two-phase estimation method to estimate the time-varying parameters and compare those estimates with real time-varying parameters. In the rst phase of SRRM, a window size of 25 time periods was chosen. As mentioned before, the crude estimators (t and t ) wiggle violently. In the second phase, we choose h = 6 and denote the nal two-phase estimates (TPEs) from the smoothing splines model as t and t . In order to evaluate the performance of the two-phase approach, we compare TPE with estimates from the rolling regression (window is 25) and the state space models. The state space models and Kalman lter have been widely used to recursively and optimally estimate time-varying betas [4].

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We use the state space representation of a time-varying parameter regression model presented by Zivot and Wang [19]. We call the previous state space model as ZW model, and it can be denoted as
2 rt = t + t rmt + t , t N (0, ),

t+1 = t + t , t N (0, 2 ), t+1 = t + t , t N (0, 2 ), t = 1, 2, . . . , T . (4)

Finally, MSE is employed to evaluate the performances of TPE, state space and rolling regression methods. The MSE is dened as MSE = 1 100(t2 t1 + 1)
100 t2

(nt t )2 ,

(5)

n=1 t=t1

where nt is the estimate for the nth simulated data at time t and t is real time-varying parameter at time t. Because each of the estimation methods has a different predicted interval, we dened (t1 , t2 ) as the predicted interval. For rolling regression, (t1 , t2 ) = (25, 200); the proposed two-phase model, (t1 , t2 ) = (12, 188) and the state space model, (t1 , t2 ) = (1, 200). The simulation results of the two-phase estimation, state space and rolling regression method are listed in Table 1. As observed from Table 1, the proposed TPEs provide more adequate results than rolling regression estimates under all the situations considered. When comparing with rolling regression estimates, the TPEs have larger gains in MSE when we estimate the alpha and beta parameters, and there is no obvious difference for the previous conclusion as a1 and b1 changed. It appears that the standard deviation ( ) of error term (t ) controls the main effects. Both TPE and rolling regression estimate have better results when is small. MSE is increasing along with the sampling error because the large sampling errors reect violent variation of asset return. Our two-phase method is very reliable because TPE is more efcient than rolling regression estimate no matter how large is. On the other hand, comparing with the state space model (ZW model), TPE is better in all situations as estimating the alpha parameter. When a1 is large, TPEs MSE is much smaller than ZW models MSE. When a1 is small, the loss of the ZW model in estimating the alpha parameter is getting smaller. For example, the ZW model and TPE have similar MSE for a1 = 0.3. The reason may be that the state space estimate tends to be overly smooth. Alpha is stable when a1 is small and the state space estimates should have more gain in efciency comparing with TPE. With regard to the estimation of system risk , TPE beats the ZW models estimate for all the choices of a1 , b1 and . Obviously, the two-phase estimation method is more reliable than the other methods as estimating beta parameter. And concerning MSE, the difference between TPE and ZW models estimates increase along with . The larger is, the bigger the gap of MSE between TPE and ZW models estimate is. There is no obvious difference between TPE and the ZW models estimates for the changes of a1 and b1 . 3.2 Sensitive study

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We estimate the time-varying parameter in two phases. In the rst phase, the length of the window controls the crude estimates of SRRM, and affects the second phase estimates. In order to understand the inuence of rolling windows, we take the length of the window on values of 13, 25, 39 and 51, and is assigned values of 2, 3, 4 and 5 under the condition that a1 = 0.5 and b1 = 0.5. For each situation, simulations of 100 replicates have been made and the results are shown in Table 2. In the case of the alpha parameter, when comparing with the TPE and state space estimate in MSE, the rolling regression estimator is the worst method. And TPEs MSE is

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Table 1. The simulation results of MSE for two-phase, rolling regression and state space model estimators under various model settings. Two-phase method a1 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 b1 0.3 0.3 0.3 0.3 0.5 0.5 0.5 0.5 0.7 0.7 0.7 0.7 0.9 0.9 0.9 0.9 0.3 0.3 0.3 0.3 0.5 0.5 0.5 0.5 0.7 0.7 0.7 0.7 0.9 0.9 0.9 0.9 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 Alpha 0.14 0.32 0.56 0.84 0.16 0.32 0.56 0.85 0.20 0.34 0.67 0.92 0.20 0.42 0.63 0.89 0.16 0.34 0.57 0.88 0.17 0.34 0.57 0.91 0.19 0.37 0.61 0.94 0.20 0.39 0.63 1.00 Beta 0.02 0.03 0.05 0.07 0.02 0.04 0.05 0.09 0.04 0.05 0.06 0.08 0.05 0.05 0.08 0.10 0.02 0.03 0.05 0.07 0.02 0.04 0.05 0.08 0.03 0.05 0.07 0.09 0.05 0.06 0.07 0.11 Rolling regression Alpha 0.22 0.42 0.74 1.07 0.27 0.46 0.76 1.10 0.30 0.49 0.89 1.21 0.35 0.59 0.84 1.19 0.33 0.54 0.78 1.22 0.31 0.55 0.82 1.25 0.38 0.58 0.89 1.30 0.42 0.65 0.94 1.35 Beta 0.06 0.07 0.11 0.13 0.13 0.16 0.18 0.21 0.28 0.27 0.30 0.34 0.41 0.44 0.45 0.48 0.06 0.07 0.09 0.14 0.14 0.16 0.19 0.21 0.26 0.28 0.29 0.32 0.42 0.43 0.46 0.52 State space Alpha 0.20 0.48 0.73 1.15 0.23 0.44 0.75 1.07 0.25 0.52 0.75 1.30 0.23 0.50 0.62 1.25 0.33 0.59 0.79 1.25 0.32 0.53 0.86 1.36 0.33 0.53 0.83 1.26 0.31 0.58 0.95 1.26 Beta 0.06 0.10 0.15 0.23 0.08 0.14 0.19 0.29 0.10 0.17 0.24 0.38 0.11 0.18 0.26 0.38 0.06 0.10 0.15 0.23 0.07 0.13 0.20 0.31 0.09 0.17 0.26 0.35 0.11 0.18 0.28 0.42 a1 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 b1 0.3 0.3 0.3 0.3 0.5 0.5 0.5 0.5 0.7 0.7 0.7 0.7 0.9 0.9 0.9 0.9 0.3 0.3 0.3 0.3 0.5 0.5 0.5 0.5 0.7 0.7 0.7 0.7 0.9 0.9 0.9 0.9 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 Two-phase method Alpha 0.15 0.33 0.58 0.93 0.18 0.33 0.61 0.87 0.20 0.37 0.61 0.95 0.23 0.40 0.61 0.96 0.16 0.36 0.63 0.87 0.18 0.34 0.58 0.83 0.20 0.37 0.67 0.91 0.22 0.38 0.66 0.98 Beta 0.02 0.03 0.05 0.07 0.02 0.03 0.05 0.08 0.03 0.04 0.06 0.09 0.04 0.06 0.08 0.11 0.02 0.03 0.05 0.08 0.02 0.03 0.05 0.08 0.03 0.05 0.06 0.08 0.04 0.06 0.07 0.10 Rolling regression Alpha 0.42 0.61 0.98 1.32 0.46 0.65 0.97 1.28 0.55 0.70 1.02 1.36 0.64 0.76 1.01 1.46 0.57 0.84 1.10 1.45 0.66 0.82 1.15 1.40 0.62 0.85 1.23 1.58 0.73 0.92 1.27 1.60 Beta 0.06 0.08 0.10 0.13 0.15 0.16 0.18 0.22 0.26 0.28 0.30 0.33 0.42 0.44 0.45 0.47 0.06 0.08 0.11 0.14 0.15 0.16 0.18 0.21 0.26 0.28 0.31 0.34 0.42 0.42 0.47 0.50 State space Alpha 0.43 0.66 1.01 1.37 0.45 0.70 0.96 1.40 0.45 0.67 0.94 1.38 0.48 0.70 0.93 1.44 0.51 0.85 1.21 1.68 0.55 0.86 1.21 1.51 0.52 0.95 1.25 1.69 0.57 0.90 1.25 1.63 Beta 0.06 0.11 0.16 0.22 0.08 0.13 0.20 0.27 0.09 0.16 0.24 0.37 0.11 0.19 0.27 0.38 0.06 0.12 0.15 0.21 0.08 0.15 0.20 0.29 0.09 0.17 0.26 0.37 0.11 0.19 0.28 0.39

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Table 2. Parameter estimates from the two-phase models with different standard deviations and rolling window sizes, and compared with those from rolling regression and state space models. Two-phase method 2 2 2 2 3 3 3 3 4 4 4 4 5 5 5 5 Windows 13 25 39 51 13 25 39 51 13 25 39 51 13 25 39 51 Alpha 0.22 0.17 0.14 0.16 0.51 0.34 0.28 0.25 0.90 0.62 0.41 0.39 1.40 0.88 0.68 0.53 Beta 0.02 0.02 0.04 0.07 0.05 0.04 0.05 0.07 0.08 0.06 0.07 0.09 0.13 0.08 0.08 0.10 Rolling regression Alpha 0.40 0.34 0.39 0.36 0.83 0.53 0.58 0.48 1.43 0.88 0.74 0.61 2.24 1.20 0.98 0.79 Beta 0.07 0.14 0.23 0.23 0.11 0.15 0.23 0.24 0.17 0.18 0.24 0.25 0.25 0.20 0.27 0.25 State space Alpha 0.30 0.34 0.31 0.30 0.51 0.53 0.60 0.55 0.85 0.87 0.94 0.92 1.17 1.22 1.36 1.31 Beta 0.08 0.07 0.08 0.08 0.13 0.13 0.14 0.14 0.19 0.20 0.21 0.22 0.27 0.28 0.31 0.31

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bigger than the state space estimators when the window length is 13. On the other hand, when the window length is larger than 13, for example 25, 39 and 51, TPE is more efcient than the state space estimate. Obviously, a window length that is too short leads to a larger variation of rolling regression estimate. And the second phase smoothing splines estimate may fail to smooth the crude estimate of the alpha parameter. When estimating the beta parameter, no matter how long the window length is, the TPE should always be more efcient than the other two methods in terms of MSE. The superiority of TPE over the other two methods does not change with different standard deviations. Consequently, if the window length of the rst phase model is not too short, the two-phase estimation method is more efcient than the rolling regression and state space methods (ZW model) in estimating time-varying parameters. As shown in Table 2, the TPE is more efcient in estimating the alpha parameter, when the rolling window is not too short. Moreover, when estimating beta parameter, if < 5, TPE has the best result when rolling window is 25. If = 5, whether the rolling window is 25 or 39 makes no difference. Hence, we suggest making the rolling window 25, and the TPE will be an efcient estimator for time-varying parameters. In the second phase estimating model, we gure out the smoothing splines estimator by using the symmetric h-nearest neighbors of crude estimates to avoid the problem of selecting the smooth parameter manually. To analyze how the choice of symmetric h-nearest neighbors inuences the TPE, we also use a simulation method to decide the length of symmetric nearest neighbors. Table 3 shows the result of different number of neighbors, as a1 = b1 = 0.5 and the standard deviation goes from 2 to 5. The TPE is more efcient than the state space and rolling regression estimator, and this result is the same as in Table 1. As the number of neighbors increases, so does the MSE of TPE, but it is not signicant. Hence, to avoid the excessive smoothness that too many neighbors bring about and to keep the characteristics of the parameters, we suggest choosing the number of neighbors as lag and lead h = 6 period for each time point. 3.3 Empirical study

To illustrate the two-phase estimation method with real data, we analyze data collected from 20 weekly equity mutual funds invested in the Taiwan stock market from January 2000 to November

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Table 3. Parameter estimates from the two-phase models with different standard deviations and k-nearest neighbors, and compared with those from rolling regression and state space models. Number of neighbors 9 (h = 4) 9 (h = 4) 9 (h = 4) 9 (h = 4) 11 (h = 5) 11 (h = 5) 11 (h = 5) 11 (h = 5) 13 (h = 6) 13 (h = 6) 13 (h = 6) 13 (h = 6) 15 (h = 7) 15 (h = 7) 15 (h = 7) 15 (h = 7) 17 (h = 8) 17 (h = 8) 17 (h = 8) 17 (h = 8) Two-phase method 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 2 3 4 5 Alpha 0.20 0.37 0.59 0.98 0.17 0.34 0.62 0.90 0.17 0.34 0.62 0.88 0.16 0.34 0.58 0.94 0.16 0.32 0.53 0.74 Beta 0.02 0.04 0.06 0.08 0.02 0.04 0.06 0.08 0.02 0.04 0.06 0.08 0.02 0.04 0.06 0.07 0.02 0.03 0.05 0.08 Rolling regression Alpha 0.41 0.52 0.80 1.23 0.34 0.57 0.85 1.18 0.34 0.53 0.88 1.20 0.33 0.57 0.89 1.30 0.37 0.57 0.83 1.10 Beta 0.14 0.16 0.18 0.21 0.14 0.16 0.18 0.21 0.14 0.15 0.18 0.20 0.14 0.16 0.18 0.22 0.14 0.16 0.19 0.20 State space Alpha 0.38 0.54 0.80 1.24 0.33 0.57 0.92 1.18 0.34 0.53 0.87 1.22 0.31 0.56 0.86 1.42 0.36 0.57 0.82 1.17 Beta 0.07 0.14 0.20 0.31 0.07 0.14 0.23 0.30 0.07 0.13 0.20 0.28 0.08 0.14 0.20 0.32 0.07 0.14 0.20 0.29

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2006. The capitalization weighted market index, TAIEX, is compiled by Taiwan Stock Exchange Corporation (TSEC). It is the most widely cited Taiwan stock market index. Return on TAIEX is used as the proxy for market portfolio returns. And we use the Bank of Taiwans 1-year deposit rates to be the risk-free rate. For the sake of simplicity, we will only show the time-varying parameter alpha and beta estimates of CAPM for President Pentium fund and Capital Marathon fund. The TPE (thick line), state space estimate (thin line) and rolling regression estimate (dashed line) are plotted in Figures 14.

Figure 1. The estimates of alpha for the President Pentium fund.

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Figure 2. The estimates of beta for the President Pentium fund.

Figure 3. The estimates of alpha for the Capital Marathon fund.

Like the previous simulation, the rolling regression estimates wiggle dramatically. And as observed in Figure 1, the variation of the rolling regression estimates is about 2.5. A similar result can be found in that the rolling regression estimate for the beta parameter wiggles as well. This does not appear to reect the real situation of mutual funds. Hence, it is necessary for rolling regression estimates to be smoothed by smoothing techniques. On the contrary, it is not like the rolling regression estimate which has large variation; the state space estimate tends to be oversmooth. As Figures 14 show, whether it is the alpha or beta parameter, the state space estimates changed slightly. Furthermore, the alphas TPE (thick line) in Figures 14 indeed smooth the rolling regression estimates and still can meet the trend of the time-varying parameter. As for the beta parameter, the system risk beta plays a correlated role between returns of the mutual fund and market portfolio. Therefore, when beta parameters change slowly, TPE will be similar to the state space estimate.

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Figure 4. The estimates of beta for the Capital Marathon fund.

As noted in the previous simulation and empirical study, the two-phase estimation model is efcient for estimating the CAPMs time-varying parameters. The alpha parameters of the President Pentium fund and Capital Marathon fund are 0.21 and 0.23 on average, respectively. It implies that the two mutual funds have a slight excess return in the study period. The beta parameters of the President Pentium fund and Capital Marathon fund are 1.02 and 1.00 on average, respectively, which are close to the 1.00 beta represented by the market in the aggregate [3]. 4. Conclusion

In this article, we propose a new two-phase estimation method to estimate the CAPMs timevarying parameters, alpha and beta. In the rst phase, we use the SRRM to estimate the timevarying parameters and call the estimates crude estimates. Moreover, we use the nonparametric estimation method, smoothing splines, as the second phase process to modify the large variation and smooth the rst phase estimates. We also propose the symmetric nearest neighbors strategy to avoid roughness and the difculty of selecting a smooth parameter manually. We emphasize that our new two-phase estimation method is very simple and can be easily obtained by widely-used software, such as Splus or R. In order to evaluate the performance of the two-phase model, we use a simulation study to demonstrate the efciency of the two-phase estimation method. Meanwhile, TPE is compared with the rolling regression and state space model. As observed in the simulation results, TPE provides more adequate results than the rolling regression estimate in all situations. Although, for the alpha parameter, the estimate of state space is better than TPE in a few cases, but one must note that the state space estimator tends to be overly smooth. For the beta parameter, TPE is more efcient than the estimate of state space model presented by Zivot and Wang [19]. Comparing with these two commonly used estimation methods for the time-varying parameters, both simulation and empirical studies show that the new two-phase method has better performances. In the proposed two-phase estimation method, only two variables, the return of the mutual fund and market portfolio, are considered in this CAPM model. It is easy to extend our model to a more complex model such as the multi-factor asset pricing model. An important feature of many series of nancial asset returns is known as volatility clustering. Volatility clustering describes

Journal of Applied Statistics

89

the tendency of large changes in asset prices to follow large changes and small changes to follow small changes. One approach to describe the previous phenomenon is to use the auto-regressive conditional heteroscedasticity (ARCH) or generalized ARCH (GARCH) model. Our simple twophase estimation method does not consider the effect of conditional heteroscedasticity in the market model residuals. In the case of strong heteroscedasticity effects, other complex models such as the ARCH or GARCH may be employed to estimate the time-varying parameters [17]. Another econometric property of time series variables is that the linear combination of two nonstationary series is stationary, and the series are called cointegrated. The coefcients of CAPM may be stable over time if the returns of asset and market portfolios are cointegrated. However, since we propose a new method for estimating time-varying parameters, therefore checking the unit root of the assets and market portfolios returns and cointegration is necessary before using our estimating method in practice. Acknowledgements
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We are most grateful to two referees for many helpful and constructive comments.

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