The Conditional Beta and the Cross-Section of Expected Returns♦

Turan G. Bali∗, Nusret Cakici, and Yi Tang

ABSTRACT

This paper examines the cross-sectional relation between conditional betas and expected stock returns
for the sample period of July 1963 – December 2004. The portfolio-level analyses and the firm-level
cross-sectional regressions indicate a positive and significant relation between conditional betas and the
cross-section of expected returns. The average return difference between high-β and low-β portfolios is
in the range of 0.89% to 1.01% per month depending on the time-varying specification of conditional
beta. After controlling for size, book-to-market, liquidity and momentum, the positive relation between
market beta and expected returns remains economically and statistically significant. These results are
robust across different measures of conditional beta, alternative portfolio partitions, firm-level and
portfolio-level cross-sectional regressions, and excluding the AMEX and NASDAQ stocks.

Key words: market beta, conditional beta, CAPM, conditional CAPM, expected stock returns
JEL classification: G10, G11, C13

♦
Turan Bali is a professor of finance at the Department of Economics and Finance, Zicklin School of Business,
Baruch College, City University of New York, One Bernard Baruch Way, Box 10-225, New York, New York
10010. Phone: (646) 312-3506, Fax: (646) 312-3451, E-mail: turan_bali@baruch.cuny.edu; Nusret Cakici is a
professor of finance at the Department of Economics, City College of New York, City University of New York,
Convent Avenue at 138th Street, New York, New York 10031, Phone: (212) 650-6204, Fax: (212) 650-6341, E-
mail: ncakici@ccny.cuny.edu; Yi Tang is a Ph.D. student at the Department of Economics and Finance, Zicklin
School of Business, Baruch College, City University of New York, One Bernard Baruch Way, Box 10-225, New
York, New York 10010, Phone: (646) 312-3396, Fax: (646) 312-3451, E-mail: yi_tang@baruch.cuny.edu.
∗
Corresponding author.
 The Conditional Beta and the Cross-Section of Expected Returns

ABSTRACT

This paper examines the cross-sectional relation between conditional betas and expected stock returns
for the sample period of July 1963 – December 2004. The portfolio-level analyses and the firm-level
cross-sectional regressions indicate a positive and significant relation between conditional betas and the
cross-section of expected returns. The average return difference between high-β and low-β portfolios is
in the range of 0.89% to 1.01% per month depending on the time-varying specification of conditional
beta. After controlling for size, book-to-market, liquidity and momentum, the positive relation between
market beta and expected returns remains economically and statistically significant. These results are
robust across different measures of conditional beta, alternative portfolio partitions, firm-level and
portfolio-level cross-sectional regressions, and excluding the AMEX and NASDAQ stocks.
 1

I. Introduction
The capital asset pricing model (CAPM) of Sharpe (1964), Lintner (1965), and Black (1972)
implies the mean-variance efficiency of the market portfolio in the sense of Markowitz (1959). The
primary implication of the CAPM is that there exists a positive linear relation between expected
returns on securities and their market betas, and variables other than beta should not capture the
cross-sectional variation in expected returns. However, over the last three decades, a large number
of studies have tested the empirical performance of the static (or unconditional) CAPM in explaining
the cross-section of realized average returns. The findings of earlier studies indicate that firm size,
book-to-market ratio, earnings-to-price ratio, liquidity, and momentum have significant explanatory
power for average stock returns, while market beta has little or no power.
Early tests of the CAPM are based on the cross-sectional regressions of average stock
returns on estimates of individual stock betas.1 Two obvious problems with these tests are errors-in-
variables and residual correlations. First, beta estimates for individual stocks are imprecise,
generating a measurement error problem when they are used to explain average returns. To improve
the accuracy of estimated betas, Blume (1970), Friend and Blume (1970), and Black, Jensen, and
Scholes (1972) use portfolios instead of individual stocks in their cross-sectional tests. Since
estimates of betas for diversified portfolios are more precise than estimates for individual stocks,
using portfolios in the cross-section regressions of average returns on betas diminishes the errors-in-
variables problem.
Second, the regression residuals have common sources of variation. Positive correlation in
the residuals yields downward bias in the usual OLS estimates of the standard errors of the cross-
sectional regression slopes. Fama and MacBeth (1973) introduce a method for addressing the
inference problem caused by correlation of the residuals in cross-sectional regressions. Rather than
estimating a single cross-section regression of average monthly returns on betas, they estimate
month-by-month cross-section of regressions of monthly returns on betas. The time-series averages
of the monthly slopes and intercepts and their standard errors are used to test whether the average
market risk premium is positive and the average intercept is equal to the risk-free rate.
In very early cross-sectional tests, Douglas (1969), Black, Jensen, and Scholes (1972), Miller
and Scholes (1972), Blume and Friend (1973), and Fama and MacBeth (1973) find that the average
slope coefficient on beta is less than the average excess market return and the intercept is greater

1 The CAPM predicts that the intercept in these cross-sectional regressions is the risk-free interest rate and the
coefficient on market beta is the expected market risk premium.
 2

than the average risk-free interest rate.2 In their widely cited study, Fama and French (1992)
examine the static version of the CAPM and find both at the firm and portfolio level that the cross-
sectional relation between market beta and average return is flat.3 They interpret this flat relation as
strong empirical evidence against the CAPM.
As indicated by Jagannathan and Wang (1996), while a flat relation between the
unconditional expected return and the unconditional market beta may be evidence against the static
CAPM, it is not necessarily evidence against the conditional CAPM. The CAPM was originally
developed within the framework of a hypothetical single-period model economy. The real world,
however, is dynamic and hence, expected returns and betas are likely to vary over time. Even when
expected returns are linear in betas for every time periods, based on the information available at the
time, the relation between the unconditional expected return and the unconditional beta could be
flat.4
There is substantial empirical evidence that conditional betas and expected returns depend
on the nature of the information available at any given point in time and vary over time.5 In this
paper, we investigate whether time-varying conditional betas can explain the cross-section of
expected returns at the firm and portfolio level. Earlier studies use either a single or rolling long
sample of monthly data in estimating beta. Rather than using a long sample of monthly data, we use
daily returns within a month to compute realized beta for each stock trading at the NYSE, AMEX,
and NASDAQ for the sample period of July 1963 to December 2004. We propose three alternative
specifications of expected future beta based on the past information on realized beta. Specifically,
we use autoregressive, moving average, and GARCH-in-mean models to obtain time-varying
conditional betas for each stock.
For each specification of conditional beta, we find that stocks with high (low) market betas
have, on average, high (low) average returns. The portfolio-level analyses and the firm-level cross-
sectional regressions indicate that the positive relation between the conditional betas and the cross-
section of average returns is economically and statistically significant. Average portfolio returns
increase almost monotonically when moving from low-beta to high-beta portfolios. The R2 values

2 The evidence that the relation between beta and average return is too flat is also confirmed in time-series tests (e.g.,

Friend and Blume (1970), and Black, Jensen, and Scholes (1972)).
3 Jegadeesh (1992) obtains results similar to Fama and French (1992).
4 This is because an asset that is on the conditional mean-variance frontier need not be on the unconditional frontier, as

Dybvig and Ross (1985) and Hansen and Richard (1987) point out.
5 An incomplete list includes Bollerslev, Engle, and Wooldridge (1988), Harvey (1989, 2001), Shanken (1990, 1992),

Ferson and Harvey (1991, 1999), Fama and French (1997), Lettau and Ludvigson (2001), Campbell and Vuolteenaho
(2004), Jostova and Philipov (2005), Petkova and Zhang (2005), Lewellen and Nagel (2006), and Ang and Chen (2005).
 3

from the regression of average portfolio returns on average portfolio betas are in the range of 82%
to 98% for 10, 20, 50, and 100 beta portfolios. When we form the equal-weighted decile portfolios
by sorting the NYSE/AMEX/NASDAQ stocks based on conditional beta, the average return
difference between decile 10 (high-β) and decile 1 (low-β) portfolios is in the range of 0.89% to
1.01% per month depending on the time-varying specification of conditional beta. For 20, 50, and
100 beta portfolios, the average return difference ranges from 1.01% to 1.23% per month. To check
whether our findings are driven by small, illiquid, and low-price stocks, we exclude the AMEX and
NASDAQ stocks and form the beta portfolios by sorting only the NYSE stocks based on the
conditional betas. The results indicate that excluding the AMEX and NASDAQ sample has almost
no effect on our original findings. We also control for the well-known cross-sectional effects
including size and book-to-market (Fama and French (1993, 1995, 1996)), liquidity (Amihud (2002)
and Pástor and Stambaugh (2003)), and past return characteristics (Jegadeesh and Titman (1993)).
After controlling for these effects, we estimate the cross-sectional beta-premium to be in the range
of 0.86% to 1.46% per month.
The paper is organized as follows. Section II contains the data and variable definitions.
Section III discusses the average raw returns and the average risk-adjusted returns on beta
portfolios. Section IV presents the firm-level cross-sectional regression results. Section V provides a
battery of robustness checks including portfolio-level cross-sectional regressions, testing long-term
predictive power of conditional betas, and some additional tests after controlling for liquidity and
momentum, after excluding the AMEX and NASDAQ sample, and after controlling for
microstructure effects. Section VI presents cross-sectional implications of the conditional CAPM
approach. Section VII concludes the paper.

II. Data and Variable Definitions

The first data set includes all New York Stock Exchange (NYSE), American Stock Exchange
(AMEX), and NASDAQ financial and nonfinancial firms from the Center for Research in Security
Prices (CRSP) for the period from July 1963 through December 2004. We use the daily stock returns
to generate the conditional beta measures. The second data set is the COMPUSTAT, which is
primarily used to obtain the book values for individual stocks.
For each month from July 1963 to December 2004, the following variables are computed for
each firm in the sample:
 4

SIZE: Following the existing literature, the firm size (ME) is measured by the natural logarithm of
the market value of equity (a stock’s price times shares outstanding in millions of dollars) for each
stock.

BOOK-TO-MARKET: Following Fama and French (1992), we compute a firm’s book-to-market

ratio (BE/ME) using its market equity at the end of December of year t–1 and the book value of
common equity plus balance-sheet deferred taxes for the firm’s latest fiscal year ending in calendar
year t–1.6

REALIZED BETA:
To estimate monthly beta for an individual stock, we assume a single factor return generating
process in the form of a market model:
R i , d , t = α i , t + β i , t R m , d ,t + ε i , d , t , (1)

where Ri ,d ,t is the daily return on stock i on day d of month t, Rm,d ,t is the daily market return on

day d of month t, and ε i ,d ,t is the residual term.7 α i,t is the intercept and β i,t is the realized beta of

stock i in month t defined as

n

Cov( Ri ,d ,t , Rm ,d ,t ) ∑ (R i , d ,t − Ri ,t )( Rm, d ,t − Rm,t )

βˆi ,t = = d =1
n
, (2)
Var ( Rm ,d ,t )
∑ (R
d =1
m , d ,t − R m ,t ) 2

where Ri ,t is the average daily return on stock i in month t, Rm ,t is the average daily market return

in month t, and n is the number of daily return observations in month t. In our empirical analysis,
Rm ,d ,t is measured by the CRSP daily value-weighted index, i.e., the daily value-weighted average

returns of all stocks trading at the NYSE, AMEX, and NASDAQ.

Earlier studies generally use monthly returns in estimating beta and testing the CAPM and
other factor models. We use daily returns and in principle, betas will be estimated more precisely
with higher-frequency data, just as Merton (1980) observed for variances. In practice, using daily

6 To avoid giving extreme observations heavy weight in our analysis, following Fama and French (1992), the smallest and
largest 0.5% of the observations on book-to-market ratio are set equal to the next largest and smallest values of the ratio
(the 0.005 and 0.995 fractiles).
7 French, Schwert, and Stambaugh (1987), Campbell, Lettau, Malkiel and Xu (2001), Goyal and Santa-Clara (2003), and

Bali, Cakici, Yan and Zhang (2005) use within-month daily returns to estimate the monthly market variance or the
monthly idiosyncratic or total volatility of each stock trading at the NYSE, AMEX, and NASDAQ.
 5

returns creates microstructure issues caused by nonsynchronous trading. Nonsynchronous prices

can have a big impact on short-horizon betas. Lo and MacKinlay (1990) show that small stocks react
with a significant (week or more) delay to common news, so daily beta will miss much of the small
stock covariance with market returns. To mitigate the problem, in the robustness check section, we
exclude the AMEX and NASDAQ stocks and control for the size effect using two-dimensional
size/beta portfolios based on the NYSE sample. Also, following Dimson (1979), we include both
current and lagged market returns in the regressions and estimate realized beta as the sum of the
slopes ( βˆi1,t and βˆi2,t ) in equation (3):

Ri ,d ,t = α i ,t + β i1,t Rm, d ,t + β i2,t Rm ,d −1,t + ε i , d ,t , (3)

where the sum of the slopes, βˆi ,t = βˆi1,t + βˆi2,t , adjusts for nonsynchronous trading (see Scholes and
Williams (1977) and Dimson (1979)).
Time-varying conditional betas are estimated based on the following autoregressive of order
one AR(1), moving average of order one MA(1), and GARCH(1,1)-in-mean models:

AR(1): β t = a0 + a1 β t −1 + ε t , E ( β t | Ω t −1 ) = β tAR ˆ 0 + aˆ1 β t −1 , E (ε t2 | Ω t −1 ) = σ 2 ,

|t −1 = a (4)

MA(1): β t = b0 + b1ε t −1 + ε t , E ( β t | Ω t −1 ) = β tMA ˆ ˆ

|t −1 = b0 + b1ε t −1 , E (ε t | Ω t −1 ) = σ , (5)
2 2

GARCH-in-mean: β t = c 0 + c1σ t2|t −1 + ε t , E ( β t | Ω t −1 ) = β tGARCH

|t −1 = cˆ0 + cˆ1σ t2|t −1 , (6)

E (ε t2 | Ω t −1 ) = σ t2|t −1 = γ 0 + γ 1ε t2−1 + γ 2σ t2−1 ,

where we drop the i subscript in equations (4)-(6) in order to save space. E ( β t | Ω t −1 ) denotes the

current conditional mean of realized beta estimated with the information set at time t–1, Ω t −1 . In

AR(1) and MA(1) models, the conditional variance of realized beta, denoted by E (ε t2 | Ω t −1 ) , is
assumed to be constant.8 In GARCH-in-mean model, the conditional variance of realized beta is
assumed to follow the GARCH(1,1) model of Bollerslev (1986).9 In this paper, we compare the
conditional betas ( β tAR
|t −1 , β t |t −1 , β t |t −1
MA GARCH
) with the lagged realized beta β trealized
−1 in terms of their

power to predict the cross-section of one-month-ahead average stock returns.

8 At an earlier stage of the study, we used AR(2), MA(2), ARMA(1,1), and ARMA(2,2) models in estimating the

conditional betas. Since the predictive power of these alternative models turns out to be similar, we choose to present
results from the most parsimonious AR(1) and MA(1) specifications.
9 The GARCH-in-mean model is originally introduced by Engle, Lilien and Robins (1987) and then used by many

researchers to model the conditional mean of asset returns as a function of the conditional volatility.
 6

Earlier studies find significant persistence in the conditional beta estimates for industry, size
or book-to-market portfolios (e.g., Braun, Nelson, Sunier (1995), and Ang and Chen (2005)).
However, these studies do not estimate conditional betas at the firm-level. Ang, Chen, and Xing
(2006) compute realized beta at the firm-level using daily returns over the past 12 months, and
propose alternative measures of downside risk based on the unconditional realized betas. According
to their descriptive statistics, the average AR(1) coefficient of realized betas are in the range of 0.077
to 0.675 depending on their specification of downside risk. Motivated by these studies, we generate
conditional beta estimates for each stock using AR(1) and MA(1) models given in equations (4)-(5).
Jagannathan and Wang (1996) examine the relation between unconditional betas and the
cross-section of unconditional expected returns by assuming that the conditional CAPM holds
period-by-period. As described in Jagannathan and Wang (1996), when the conditional CAPM is
assumed to hold for each period, cross-sectionally, the unconditional expected return on any asset is
a linear function of its expected beta and its beta-premium sensitivity. In other words, the standard
static (or unconditional) CAPM leads to a two-factor unconditional asset pricing model, where the
first factor is the unconditional market beta that measures average market risk and the second factor
is the unconditional premium beta which measures beta-instability risk. According to this model,
stocks with higher expected betas should have higher unconditional expected returns. Similarly,
stocks with betas that are correlated with the market risk premium and hence are less stable over the
business cycle should also have higher unconditional expected returns. Jagannathan and Wang
(1996) indicate that the beta-premium sensitivity of an asset measures the instability of the asset’s
beta over the business cycle.
Motivated by the conditional CAPM literature, we model the conditional mean of market
beta as a function of its conditional variance as in the GARCH-in-mean specification. Equation (6)
models the current conditional mean and conditional variance of realized betas as a function of the
information set at time t–1.
To provide an alternative justification for our use of the GARCH-in-mean model, we
compute the correlations between (i) the realized beta ( β t ) and the conditional standard deviation
of realized beta ( σ t ); (ii) the realized beta ( β t ) and the conditional variance of realized beta ( σ t );
(iii) the conditional mean of realized beta ( E ( β t | Ω t −1 ) ) and the conditional standard deviation of
realized beta ( σ t ); and (iv) the conditional mean of realized beta ( E ( β t | Ω t −1 ) ) and the conditional
variance of realized beta ( σ t ).
 7

The panel below presents the percentiles of the correlation measures for all stocks trading at the
NYSE, AMEX, and NASDAQ. The correlation statistics indicate a strong relation between the
monthly realized betas and their conditional volatility as well as a strong relation between the
conditional mean of monthly realized betas and their conditional volatility.

Correlation βt , σ t β t , σ t2 E ( β t | Ω t −1 ) , σ t E ( β t | Ω t −1 ) , σ t2
1% -0.625 -0.650 -0.988 -0.989
5% -0.390 -0.422 -0.971 -0.973
10% -0.272 -0.301 -0.944 -0.946
20% -0.150 -0.168 -0.838 -0.826
30% -0.069 -0.080 -0.505 -0.474
40% 0.002 -0.004 0.073 0.066
50% 0.067 0.067 0.583 0.549
60% 0.130 0.135 0.791 0.773
70% 0.196 0.204 0.882 0.877
80% 0.273 0.287 0.929 0.931
90% 0.390 0.412 0.963 0.967
95% 0.493 0.520 0.979 0.981
99% 0.696 0.711 0.992 0.993

Similarly, the estimated slope coefficients ( ĉ1 ) in β t = c 0 + c1σ t2|t −1 + ε t are found to be statistically

significant which provides further justification of our use of the GARCH-in-mean model.

Table I presents percentiles of the time-series mean and standard deviation of realized and
expected conditional betas. The statistics presented in Panel A of Table I are based on realized betas
computed using daily returns over the previous month without lagged market return. The statistics
shown in Panel B of Table I are based on realized betas computed using daily returns over the
previous month with the lagged market return. In both panels, we only report the sample mean of
the realized betas because theoretically the mean of conditional betas is the same as the mean of
realized beta. Theoretically, the means should be the same, but the discrepancies are caused by the
filtration of conditional beta. As expected, the standard deviation of realized betas is greater than the
standard deviation of expected betas. In both panels, the standard deviation of conditional betas
obtained from the GARCH-in-mean model is somewhat greater than the standard deviation of
conditional betas obtained from the AR(1) and MA(1) models.
 8

We compare the conditional betas ( β tAR

|t −1 , β t |t −1 , β t |t −1
MA GARCH
) with the lagged realized beta

β trealized
−1 in terms of their power to predict the one-month-ahead realized beta, β trealized . Table II
shows the percentiles of R2 values from the regression of one-month-ahead realized betas on the
lagged realized beta and conditional betas. The performance of conditional betas in predicting the
one-month-ahead realized beta is much higher than the lagged realized beta. The one percentile of
R2 is 0.01% for β trealized
−1 and the 99 percentile of R2 is 26.82%. The corresponding figures are 1.14%

and 33.87% for β tGARCH

|t −1 .

These results provide some explanation for why the earlier studies that use lagged realized
beta or unconditional beta could not identify a positive and significant relation between market beta
and expected stock returns. We think that to generate more accurate measures of expected futures
betas and to explain the cross-sectional variation in stock returns, one needs to use conditional
betas.

III. Average Returns and FF-3 Alphas on Beta Portfolios

A. Univariate Portfolio-Level Analysis
Table III presents the equal-weighted average returns of decile portfolios that are formed by
sorting the NYSE/AMEX/NASDAQ stocks based on the lagged realized beta, and the conditional
AR(1), MA(1), and GARCH-in-mean betas. The results in Panel A of Table III are based on the
realized betas computed using daily returns over the previous month without lagged market return.
When portfolios are sorted based on the lagged realized beta, β trealized
−1 , the average return
difference between decile 10 (high-β) and decile 1 (low-β) is about –0.49% per month with the
Newey-West (1987) t-statistic of –2.53. Although this result provides evidence against the empirical
validity of CAPM, it is not conclusive because as discussed earlier β trealized
−1 is not a precise estimator

of β trealized . The static CAPM predicts a contemporaneous positive relation between expected stock
returns and market betas. However, we cannot use the current realized beta in empirical tests
because of the statistical problems indicated by Miller and Scholes (1972) and Fama and MacBeth
(1973).
We now examine the cross-sectional predictive power of the conditional beta measures
which are shown to be more accurate estimators of β trealized . When decile portfolios are sorted based
 9

on β tAR
|t −1 , β t |t −1 , and β t |t −1
MA GARCH
, the average return difference between decile 10 (high-β) and decile 1

(low-β) is in the range of 0.74% to 0.92% per month and highly significant.
In addition to the average raw returns, Panel A of Table III also presents the magnitude and
statistical significance of the intercepts (FF-3 alphas) from the regression of the equal-weighted
portfolio returns on a constant, excess market return, SMB and HML factors. As shown in Panel A
of Table III, the 10-1 difference in the FF-3 alphas is negative for β trealized
−1 , but it is positive and
highly significant for the AR(1), MA(1), and GARCH-in-mean betas.
The results shown in Panel B of Table III are based on the realized betas computed using
daily returns over the previous month with the lagged market return. When portfolios are sorted
based on β trealized
−1 , the average return difference between high-β and low-β portfolios is negative but

marginally significant. When decile portfolios are sorted based on β tAR

|t −1 , β t |t −1 , and β t |t −1
MA GARCH
, the

average return difference between high-β and low-β portfolios is positive, in the range of 0.89% to
1.01% per month, and highly significant. Panel B of Table III also shows that the 10-1 difference in
the FF-3 alphas is negative for β trealized
−1 , but it is positive and highly significant for the AR(1), MA(1),
and GARCH-in-mean betas. Overall, the results in Table III indicate that the strong positive relation
between the conditional betas and expected returns is robust to the measurement of realized betas.
To save space, in the following sections, we report results only from the realized beta
measures estimated with the lagged market return.

B. Controlling for Size and Book-to-Market

We test whether there is a positive relation between conditional beta and expected returns
after controlling for size and book-to-market. We control for size by first forming decile portfolios
ranked based on market capitalization. Then, within each size decile, we sort stocks into decile
portfolios ranked based on GARCH-in-mean beta so that decile 1 (10) contains stocks with the
lowest (highest) market beta. Panel A of Table IV shows that in each size decile, the highest (lowest)
beta decile has a higher (lower) average returns. The column labeled “Average Returns” averages
across the 10 size deciles to produce decile portfolios with dispersion in market beta, but which
contain all sizes of firms. This procedure creates a set of decile beta portfolios with near-identical
levels of firm size and thus these decile beta portfolios control for differences in size. After
controlling for size, the average return difference between high-β and low-β portfolios is 1.41% per
 10

month with the Newey-West t-statistic of 3.48. Thus, market capitalization does not explain the high
(low) returns to high (low) beta stocks.
We also control for book-to-market (BM) by first forming decile portfolios ranked based on
the ratio of book value of equity to market value of equity. Then, within each BM decile, we sort
stocks into decile portfolios ranked based on GARCH-in-mean beta so that decile 1 (10) contains
stocks with the lowest (highest) market beta. Panel B of Table IV shows that in each BM decile, the
highest (lowest) beta decile has a higher (lower) average returns. The last two columns report the
average returns and Newey-West t-statistics of 10 beta portfolios after controlling for BM. The
average return difference between high-β and low-β portfolios is 1.16% per month with the Newey-
West t-statistic of 3.69. Thus, book-to-market ratio does not explain the high (low) returns to high
(low) beta stocks.10
Table V shows the average return differences and FF-3 alphas on high-β minus low-β
portfolios within each size and book-to-market decile. As shown in Panel A of Tabel V, for all
specifications of conditional beta, the average return differences and FF-3 alphas are positive and
economically significant within each size decile. Except for the two biggest size portfolios (Size-9,
Size-10), the average return differences and FF-3 alphas are also statistically significant at the 5%
level or better. For example, for the smallest size decile, the average return difference between decile
10 (high-β) and decile 1 (low-β) is 2.49% per month for β tAR
|t −1 , 2.57% per month for β t |t −1 , and
MA

2.50% per month for β tGARCH

|t −1 . The corresponding FF-3 alphas are 2.02% per month for β tAR
|t −1 ,

2.06% per month for β tMA

|t −1 , and 2.02% per month for β t |t −1
GARCH
. This strong positive relation between

market beta and expected return is present for Size-1 to Size-9 portfolios, and the relation becomes
somewhat weaker for the largest size portfolio (Size 10).
Panel B of Table V shows that for all specifications of conditional beta, the average return
differences and FF-3 alphas are positive and economically significant within each book-to-market
decile. The average return differences and FF-3 alphas are also statistically significant at the 5% level
or better. For example, for the lowest BM decile, the average return difference between decile 10
(high-β) and decile 1 (low-β) is 1.50% per month for β tAR
|t −1 , 1.49% per month for β t |t −1 , and 1.29%
MA

per month for β tGARCH

|t −1 . The corresponding FF-3 alphas are 1.60% per month for β tAR
|t −1 , 1.54% per

10In Table IV, decile portfolios are formed based on the GARCH-in-mean beta estimates. The results from the AR(1)
and MA(1) models are very similar to those in Table IV. They are available from the authors upon request.
 11

month for β tMA

|t −1 , and 1.36% per month for β t |t −1
GARCH
. Although there is no obvious pattern, the strong

positive relation between market beta and expected return is more pronounced for BM-1 to BM-9
portfolios, and the relation becomes weaker for the highest BM portfolio.
To check whether the results in Tables IV and V are driven by small and illiquid stocks, in
the robustness check section, we report average returns from the double-sort size/beta and
BM/beta portfolios after excluding the AMEX and NASDAQ stocks. As will be discussed, after
controlling for size and book-to-market, we find a positive and highly significant relation between
conditional betas and the cross-section of expected returns for the NYSE sample as well.

IV. Firm-Level Cross-Sectional Regressions

We have so far tested the significance of conditional beta measures at the portfolio level. We
will now examine the cross-sectional relation between market beta and expected returns at the firm
level using Fama and MacBeth (1973) regressions.
We present the time-series averages of the slope coefficients from the cross-section of
average stock returns on the lagged realized beta, conditional beta, size, and book-to-market. The
average slopes provide standard Fama-MacBeth tests for determining which explanatory variables
on average have non-zero expected premiums. Monthly cross-sectional regressions are run for the
following econometric specifications:
Ri ,t = γ 0,t + γ 1,t β irealized
,t −1 + γ 2,t log MEi ,t −1 + γ 3,t log( BE i ,t −1 / MEi ,t −1 ) + ε i ,t , (7)

Ri ,t = γ 0,t + γ 1,t β iAR

,t |t −1 + γ 2 ,t log ME i ,t −1 + γ 3,t log( BE i ,t −1 / ME i ,t −1 ) + ε i ,t , (8)

Ri ,t = γ 0,t + γ 1,t β iMA

,t |t −1 + γ 2 ,t log ME i ,t −1 + γ 3,t log( BE i ,t −1 / ME i ,t −1 ) + ε i ,t , (9)

Ri ,t = γ 0,t + γ 1,t β iGARCH

,t |t −1 + γ 2,t log ME i ,t −1 + γ 3,t log( BE i ,t −1 / ME i ,t −1 ) + ε i ,t , (10)

where Ri ,t is the realized return on stock i in month t, log MEi ,t −1 is the natural logarithm of market

equity for firm i in month t–1, log( BEi ,t −1 / MEi ,t −1 ) is the natural logarithm of the ratio of book

value of equity to market value of equity for firm i in month t–1, β irealized
,t −1 is the lagged realized beta

of stock i in month t–1, and β iAR

,t |t −1 , β i ,t |t −1 , and β i ,t |t −1
MA GARCH
are the conditional expected beta of stock i

in month t estimated with the information set at month t–1.

Table VI reports the time series averages of the slope coefficients γi,t (i = 1, 2, 3) over the
498 months from July 1963 to December 2004. The Newey-West adjusted t-statistics are given in
 12

parentheses. The results show a negative but insignificant relation between the lagged realized beta
and the cross-section of average stock returns since the average slope, γ1,t, from the monthly
regressions of realized returns on β irealized
,t −1 alone is about –0.07% with a t-statistic of –1.19. The
univariate regression results indicate a significantly positive relation between average stock returns
and conditional betas. The average slope, γ1,t, from the monthly regressions of realized returns on
β iAR
,t |t −1 , β i ,t |t −1 , or β i ,t |t −1
MA GARCH
is in the range of 0.44% to 0.50% and statistically significant at the 5% or

better. These values imply a reasonable expected market risk premium of 5.33% to 5.87% per
annum.
The univariate regression results also indicate a significantly negative relation between
average stock returns and firm size. The average slope, γ2,t, from the monthly regressions of realized
returns on log MEi ,t −1 alone is about –0.24% with a t-statistic of –4.75. The parameter estimates
show a significantly positive relation between average stock returns and book-to-market ratio. The
average slope, γ3,t, from the monthly regressions of realized returns on log( BEi ,t −1 / MEi ,t −1 ) alone is
about 0.42% with a t-statistic of 5.98. The findings of negative size and positive book-to-market
effect in Fama-MacBeth regressions are consistent with Fama and French (1992) and related studies.
The strong positive relation between conditional beta and expected stock returns is found to
be robust across different econometric specifications. When we include size to the univariate
regressions the average slope coefficient on β iAR
,t |t −1 , β i ,t |t −1 , or β i ,t |t −1
MA GARCH
is about 0.80% and statistically

significant at the 1% level. When book-to-market is included to the univariate regressions, the
average slope coefficient on conditional betas is in the range of 0.65% to 0.68% and statistically
significant at the 1% level. When both size and book-to-market are included to the univariate
regressions, the average slope coefficient on the conditional betas is about 0.90% and statistically
significant at the 1% level.
The R2 values from the univariate regressions of realized returns on conditional beta are in
the range of 2.02% to 2.13%. When size and book-to-market are included to these univariate
regressions, the R2 values increase to 4.70% to 4.87%. Although the R2 values from univariate and
multivariate cross-sectional regressions are small, they are consistent with the earlier studies that
report R2 for the firm-level cross-sectional regressions.
Brennan, Chordia, and Subrahmanyam (1998) show that the standard Fama-MacBeth (1973)
approach presents problems if the independent variables used in the cross-sectional regressions (i.e.,
 13

factor loadings such as beta) are measured with error. One method of dealing with this measurement
error problem is to use the information from the first-stage regressions (in which the factor loadings
are estimated) to correct the coefficient estimates in the second stage regressions. To deal with this
errors-in-variables problem, Brennan et al. (1998) first obtain monthly slope coefficients from the
standard Fama-MacBeth regressions, and then run a time-series regression of the slope coefficients
on the factor portfolio returns. The intercept and its standard error from the second-stage time-
series regression are used to test the null hypothesis. The authors call the intercept purged estimator
because it purges the monthly estimates of the factor dependent component.
In our context, to correct for measurement error in the average slope coefficients on realized
and conditional betas, we first obtain the monthly slope coefficients ( γ 1,t ) from the cross-sectional

regressions: Ri ,t = γ 0,t + γ 1,t β irealized

,t −1 + ε i ,t , Ri ,t = γ 0,t + γ 1,t β iAR
,t |t −1 + ε i ,t , Ri ,t = γ 0 ,t + γ 1,t β i ,t |t −1 + ε i ,t ,
MA

and Ri ,t = γ 0,t + γ 1,t β iGARCH

,t |t −1 + ε i ,t . Then, we construct two alternative beta-mimicking portfolios. At

the beginning of each month from July 1963 to December 2004, all NYSE/AMEX/NASDAQ
stocks are sorted into 10 beta portfolios with the NYSE and CRSP breakpoints. The value-weighted
average return difference between decile 10 and decile 1 is used as a proxy for the realization of the
beta-related risk factor. Once we generate two alternative factor portfolio returns based on the
CRSP and NYSE breakpoints, we regress γ 1,t on a constant and the factor portfolio returns that

mimic beta-related risk factor (Ft):

γ 1,t = θ 0 + θ1 Ft + u t ,
)
where the intercept θ 0 is the purged estimator of the average slope coefficient on β irealized
,t −1 , β iAR
,t |t −1 ,

β iMA
,t |t −1 , and β i ,t |t −1 .
GARCH

The results in Panel B of Table VI show that the intercept is economically and statistically
insignificant for the lagged realized beta, whereas the intercepts for AR(1), MA(1), and GARCH-in-
mean beta estimates are positive and highly significant. The magnitude and statistical significance of
the intercepts are very similar for the two beta-mimicking portfolios generated with the CRSP and
NYSE breakpoints. In fact, the t-statistics of the intercepts presented in Panel B are not different
from the t-statistics of the average slope coefficients reported in Panel A of Table VI. Hence, we
conclude that the potential errors-in-variables problem in our conditional beta estimates is not
significant enough to alter our main conclusions.
 14

In addition to the slope coefficients from the univariate Fama-MacBeth regressions, we also
correct for measurement error in the slope coefficients from the multivariate regressions with size
and book-to-market. However, as shown in Panel A of Table VI, the magnitude and statistical
significance of the average slope coefficients on the conditional betas are much higher in the
multivariate regressions than in the univariate regressions. Hence, after correcting for the errors-in-
variables problem, the Newey-West t-statistics of the intercepts indicate 1% level of significance.

V. Robustness Check
A. Alternative Portfolio Partitions
Table VII presents the equal-weighted average returns of 20, 50, and 100 portfolios that are
formed by sorting the NYSE/AMEX/NASDAQ stocks based on the conditional AR(1), MA(1),
and GARCH-in-mean betas. The average return difference between high-β and low-β portfolios is
in the range of 0.83% to 1% per month for β tAR
|t −1 , 0.89% to 1.11% per month for β t |t −1 , and 1.06%
MA

to 1.31% per month β tGARCH

|t −1 . All these average return differences are statistically significant at the

5% level or better. In addition to the average raw returns, Table VII also reports the magnitude and
statistical significance of the FF-3 alphas. The 10-1 difference in the FF-3 alphas is positive and
highly significant for the AR(1), MA(1), and GARCH-in-mean betas.
In addition to the firm-level Fama-MacBeth regressions, we examine the cross-sectional
relation between conditional beta and expected returns at the portfolio level. We present the time-
series averages of the slope coefficients from the cross-section of average portfolio returns on the
conditional portfolio beta:
R p ,t = γ 0,t + γ 1,t β pAR
,t |t −1 + ε i ,t , (11)

R p ,t = γ 0,t + γ 1,t β pMA

,t |t −1 + ε i ,t , (12)

R p ,t = γ 0,t + γ 1,t β pGARCH

,t |t −1 + ε i ,t , (13)

where R p ,t is the realized return on portfolio p in month t calculated as the equal-weighted average

returns of all stocks in portfolio p, and β pAR,t|t −1 , β pMA

,t |t −1 , and β p ,t |t −1
GARCH
are the conditional expected

beta of portfolio p obtained from the equal-weighted average conditional beta of all stocks in
portfolio p in month t estimated with the information set at month t–1.
 15

First, we form 10, 20, 50, and 100 portfolios by sorting the NYSE/AMEX/NASDAQ
stocks based on the conditional AR(1), MA(1), and GARCH-in-mean betas. Then, for each month
from July 1963 to December 2004, we compute each portfolio’s return as the equal-weighted
average return of all stocks in the portfolio. Similarly, we calculate the portfolio’s conditional beta as
the equal-weighted average conditional beta of all stocks in the portfolio. Finally, we run the
univariate regressions of average portfolio returns on the average conditional portfolio beta for each
month from July 1963 to December 2004.
Table VIII presents the time series averages of the slope coefficients and the Newey-West
adjusted t-statistics in parentheses. The univariate regression results indicate a significantly positive
relation between average portfolio returns and average portfolio betas. For 10-beta portfolios, the
average slope from the monthly regressions of average portfolio returns on β pAR,t|t −1 , β pMA
,t |t −1 , and

β pGARCH
,t |t −1 is about 0.44%, 0.47%, and 0.53%, respectively. These average slope coefficients have a

Newey-West t-statistic of 2.25, 2.37, and 2.61, respectively. A notable point in Table VIII is that for
20, 50, and 100 beta-portfolios, the average slope coefficients are very similar. In other words, the
results are very robust across different portfolio formations. These slope coefficients, which imply
an expected market risk premium of 5.28% to 6.36% per annum, are also very similar to our earlier
findings from the firm-level cross-sectional regressions. The difference between the results reported
in Table VI and VIII is the magnitude of R2 values. As expected, the R2 values are much higher for
the portfolio-level regressions. More specifically, the R2 measures are about 58%-59% for 10-beta
portfolios, 48%-49% for 20-beta portfolios, 35%-36% for 50-beta portfolios, and 25%-26% for 100-
beta portfolios.
In addition to the month-by-month Fama-MacBeth regressions, we take the time-series
average of the monthly portfolio returns and the monthly portfolio betas and compute overall
average portfolio return and overall average portfolio beta for 10, 20, 50, and 100 portfolios. Figures
1-4 plot the average portfolio return against the average portfolio beta and provide a strong positive
relation between market beta and expected returns for all portfolio partitions. The R2 value is
97.94% for 10-beta portfolios, 95.97% for 20-beta portfolios, 88.47% for 50-beta portfolios, and
81.50% for 100-beta portfolios. We also report the slope coefficients for each portfolio partition in
Figures 1-4. The results are very similar to our earlier findings from the month-by-month firm-level
and portfolio-level Fama-MacBeth regressions: As shown in Figures 1-4, the slope on average
 16

portfolio beta is almost identical for different portfolio partitions: 0.53% for 10, 50, and 100-beta
portfolios, and 0.52% for 20-beta portfolios.

B. Long Term Predictive Power of Conditional Betas

We have so far tested the significance of conditional beta measures for one-month ahead
predictability of stock and portfolio returns. That is, the conditional betas are estimated using the
information set at time t–1 and their pattern is compared with the cross-section of average stock and
portfolio returns at time t. We will now investigate whether the conditional betas can predict the 2-
month, 3-month,… and up to 12-month ahead returns.
Table IX presents the equal-weighted returns of decile portfolios that are formed by sorting
the NYSE/AMEX/NASDAQ stocks based on the conditional GARCH-in-mean betas.11 The first
column repeats our earlier result for 1-month ahead predictability: When decile portfolios are sorted
based on β tGARCH
|t −1 , the average return difference between decile 10 (high-β) and decile 1 (low-β) is

1.01% per month with the Newey-West t-statistic of 2.83. To test 3-month ahead predictability, we
form decile portfolios by sorting stocks based on their conditional betas at time t–2 obtained from
the information set at time t–3, β tGARCH
− 2|t −3 . The average return difference between high-β and low-β

portfolios is 0.93% per month with the t-statistic of 2.60. As shown in Table IX, the conditional
beta can predict up to 12-month ahead because the average return difference between high-β and
low-β portfolios is 0.75% per month with the t-statistic of 2.09.
In addition to the average raw returns, Table IX also presents the magnitude and statistical
significance of the FF-3 alphas from the regression of the equal-weighted portfolio returns on a
constant, excess market return, SMB and HML factors. The 10-1 difference in the FF-3 alphas is
positive and significant at the 5% level or better up to 9-month ahead predictability. However, the
economic and statistical significance of FF-3 alpha gradually reduce to 0.43% per month with the t-
statistic of 1.88 for 12-month ahead returns.

C. Controlling for Liquidity and Momentum

This section investigates whether the positive relation between conditional beta and the
cross-section of expected returns holds after controlling for liquidity and momentum.

11 To save space, we do not present the results from β iAR

,t |t −1 and β i ,t |t −1 , which are very similar to those in Table IX.
MA

They are available upon request.

 17

Liquidity generally implies the ability to trade large quantities quickly, at low cost, and
without inducing a large change in the price level. Following Amihud (2002), we measure stock
illiquidity as the ratio of absolute stock return to its dollar volume:
ILLIQi ,t =| Ri ,t | / VOLDi ,t , (14)
where Ri,t is the return on stock i in month t, and VOLDi,t is the respective monthly volume in
dollars. This ratio gives the absolute percentage price change per dollar of monthly trading volume.
As discussed in Amihud (2002), ILLIQi,t follows the Kyle’s (1985) concept of illiquidity, i.e., the
response of price to the associated order flow or trading volume. The measure of stock illiquidity
given in equation (14) can be interpreted as the price response associated with one dollar of trading
volume, thus serving as a rough measure of price impact.
We control for liquidity by first forming decile portfolios ranked based on the illiquidity
measure of Amihud (2002). Then, within each illiquidity decile, we sort stocks into decile portfolios
ranked based on the GARCH-in-mean betas so that decile 1 (10) contains stocks with the lowest
(highest) market beta. Although not presented in the paper, in each illiquidity decile, the highest
(lowest) beta decile has a higher (lower) average returns. The column labeled “Illiquidity” in Panel A
of Table X presents the average returns across the 10 illiquidity deciles to produce decile portfolios
with dispersion in market beta. This procedure creates a set of decile beta portfolios with near-
identical levels of illiquidity. Thus, these decile beta portfolios control for differences in illiquidity.
After controlling for illiquidity, the average return difference between high-β and low-β portfolios is
1.20% per month with the Newey-West t-statistic of 3.05. Thus, liquidity does not explain the high
(low) returns to high (low) beta stocks.
Alternatively, we measure liquidity of individual stocks using dollar trading volume and
obtain similar results. The column labeled “Volume” in Panel A of Table X presents the average
returns across the 10 volume deciles to produce decile portfolios with dispersion in market beta.
After controlling for dollar trading volume, the average return increase monotonically from 0.92%
to 2.38% when moving from low-β to high-β portfolios. The average return difference between
high-β and low-β portfolios is 1.46% per month with the Newey-West t-statistic of 3.68. Thus,
trading volume does not explain the high (low) returns to high (low) beta stocks either.
We control momentum by first forming decile loser-winner portfolios ranked based on the
past 6-month average returns of individual stocks. Then, within each 6-month momentum portfolio,
we sort stocks into decile portfolios ranked based on GARCH-in-mean beta so that decile 1 (10)
contains stocks with the lowest (highest) market beta. The column labeled “MOM6” in Panel A of
 18

Table X presents the average returns across the 10 momentum deciles to produce decile portfolios
with dispersion in market beta. This procedure creates a set of decile beta portfolios with near-
identical levels of past average 6-month returns. Thus, these decile beta portfolios control for
differences in momentum. After controlling for momentum, the average return difference between
high-β and low-β portfolios is 0.99% per month with the Newey-West t-statistic of 2.89. Thus,
momentum does not explain the high (low) returns to high (low) beta stocks. Similar results are
obtained when we form loser-winner portfolios based on the past 12-month average returns
(MOM12). The average return difference between high-β and low-β portfolios is 0.86% per month
with the t-statistic of 2.74.
Finally, we investigate whether the positive relation between conditional beta and the cross-
section of expected returns holds in the firm-level Fama-MacBeth regressions after controlling for
liquidity, momentum, size, and book-to-market.
Table XI presents the time series averages of the slope coefficients and the Newey-West
adjusted t-statistics in parentheses. The regression results indicate a significantly positive relation
between average stock returns and the conditional GARCH-in-mean betas after controlling for
illiquidity, trading volume, past average 6-month and 12-month returns with and without size and
book-to-market. The average slope coefficient on β tGARCH
|t −1 is about 0.51% with ILLIQt −1 and 0.52%

with VOLt −1 , and both coefficients are highly significant. The average slope coefficient on β tGARCH
|t −1 is

about 0.41% and significant at the 5% level when MOM 6 t −1 or MOM 12 t −1 is included along with

β tGARCH
|t −1 in the cross-sectional regressions.

When alternative measures of liquidity and momentum are included along with β tGARCH
|t −1 , size

and book-to-market, the average slope coefficient on β tGARCH

|t −1 becomes very stable in the range of

0.62% to 0.66% for different specifications. As shown in Table XI, for all these multivariate
regressions with liquidity, momentum, size, and book-to-market, the average slope coefficient on
β tGARCH
|t −1 is statistically significant at the 1% level.

At an earlier stage of the study, we replicated our results presented in Tables X and XI using
the conditional beta estimates obtained from the AR(1) and MA(1) specifications. The results turn
out to be very similar to those from β tGARCH
|t −1 . To save space, we do not present our findings from

β iAR
,t |t −1 and β i ,t |t −1 . They are available upon request.
MA
 19

D. Results from the NYSE Sample

We have so far presented results from the NYSE/AMEX/NASDAQ sample which includes
small, illiquid, and low-price stocks. To check the robustness of our findings, we exclude the AMEX
and NASDAQ stocks and form the beta portfolios by sorting only the NYSE stocks based on the
conditional GARCH-in-mean betas. Table XII shows that for the univariate sort of NYSE stocks,
the average return difference between high-β and low-β portfolios is about 0.86% with the Newey-
West t-statistic of 2.79. The 10-1 difference in the FF-3 alphas is 0.37% with the t-statistic of 2.44.
In addition to the univariate sorts, we further examine the cross-sectional relation by
forming the beta portfolios within each size and book-to-market deciles. As presented in Table XII,
the average return difference between high-β and low-β portfolios is 0.84% after controlling for size
and 0.78% after controlling for book-to-market. Both return differences are statistically significant at
the 1% level. The 10-1 differences in the FF-3 alphas are also positive and highly significant. These
results indicate that excluding the AMEX and NASDAQ sample has almost no effect on our
previous findings. These results remain the same for alternative specifications of conditional beta
( β iAR
,t |t −1 and β i ,t |t −1 ).
MA

E. Controlling for Microstructure Effects and NYSE Breakpoint

In the previous section, we excluded the AMEX and NASDAQ stocks and presented the
return/beta estimates from the portfolios of NYSE stocks formed based on the NYSE breakpoints.
However, these results may be contaminated with microstructure effects because there is only one
month gap between the conditional beta estimates and portfolio returns. In this section, we skip the
month following portfolio formation to avoid microstructure effects and use the NYSE breakpoints
following Fama and French (1992) to generate beta portfolios of NYSE/AMEX/NASDAQ stocks
with a relatively more balanced average market share.12
Table XIII presents the average returns on the beta portfolios of NYSE/AMEX/NASDAQ
stocks with NYSE breakpoints after skipping the month following portfolio formation. When
portfolios are sorted based on the lagged realized beta, the average return difference between high-β
and low-β portfolios is economically and statistically insignificant. When portfolios are formed based
on the AR(1), MA(1), and GARCH-in-mean beta estimates, the average return difference between

12 Since there are so many small NASDAQ stocks in terms of market capitalization, portfolio breakdowns are

determined using only NYSE stocks to avoid the beta portfolios which contain small stocks from being too small in
terms of average market share.
 20

decile 10 and 1 is about 0.70%, 0.72%, and 0.92% per month, respectively. Similar to our earlier
findings, for all conditional beta estimates, the 10-1 differences in average returns and FF-3 alphas
are positive and highly significant. Overall, the results in Table XIII indicate that forming portfolios
with CRSP or NYSE breakpoints and skipping the month following portfolio formation do not
affect our main conclusions.

F. Controlling for Size and Book-to-Market Simultaneously

When constructing beta portfolios, we control for size or book-to-market ratio, but not
both. In this section, we test whether the significantly positive relation between conditional beta and
expected returns remains intact after controlling for size and book-to-market simultaneously.
Table XIV presents average returns and FF-3 alphas on the quintile portfolios of realized
and conditional betas after controlling for size and book-to-market. At the beginning of each month
t from July 1963 to December 2004, all NYSE/AMEX/NASDAQ stocks are first sorted into 5 size
(market equity) portfolios. Then within each size portfolio, stocks are sorted into 5 BM (book-to-
market equity ratio) portfolios. Finally, within each portfolio formed based on the intersections of 5
size and 5 BM portfolios, stocks are sorted into 5 beta portfolios based on their realized and
conditional betas in month t-1.
As shown in Table XIV, when stocks in the 5 × 5 size/BM portfolios are sorted into five
realized beta ( β trealized
−1 ) portfolios, the average return difference between high-β and low-β portfolios
is about 0.04% per month with a t-statistic of 0.32. Similar to our earlier findings from the univariate
and bivariate sorts, there is no significant relation between lagged realized beta and the cross-section
of expected returns from trivariate sorts either. When stocks in the 5 × 5 size/BM portfolios are
sorted into five AR(1), MA(1), and GARCH-in-mean beta portfolios, the average return difference
between high-β and low-β portfolios is about 1.09%, 1.10%, and 1.13% per month, respectively, and
these return differences are statistically significant at the 1% level. Moreover, for all conditional beta
estimates, the 5-1 differences in FF-3 alphas are positive and highly significant. Overall, the results in
Table XIV indicate that the significantly positive relation between conditional beta and the cross-
section of expected returns remains the same after controlling for both size and book-to-market.
As discussed in Section IV, we control for both size and book-to-market when we run the
firm-level cross-sectional regressions, and as shown in Panel A of Table VI, the average slope
coefficients on the conditional beta estimates remain to be positive and highly significant after
 21

controlling for size and book-to-market (see the last 3 rows in Panel A of Table VI). Given that we
have a significantly positive relation between conditional beta and expected returns from the firm-
level Fama-MacBeth regressions, the results from the 5 × 5 × 5 size/BM/beta portfolios shown in
Table XIV are not surprising.

VI. Cross-Sectional Implications of the Conditional CAPM

The static (or unconditional) capital asset pricing model (CAPM) of Sharpe (1964), Lintner
(1965), and Black (1972) indicates that there exists a positive linear relation between expected
returns on securities and their market betas:
E ( Ri , t ) = β i E ( R m , t ) , (15)

where E ( Ri ,t ) is the unconditional expected excess return of asset i, E ( Rm,t ) is the unconditional
expected excess return of the market portfolio, and β i = Cov ( Ri ,t , Rm,t ) / Var ( Rm,t ) is the
unconditional beta of asset i.
Fama and French (1992) and related studies find that the unconditional market beta cannot
explain the cross-sectional variation in expected stock returns. The unconditional CAPM was
derived by examining the behavior of investors in a hypothetical model in which they live for only
one period. In the real world investors live for many periods. Hence, in the empirical examination of
the CAPM, using data from the real world, it is necessary to make certain assumptions. One of the
most commonly made assumptions in the static CAPM framework is that that the betas of the assets
remain constant over time. However, this is not a reasonable assumption because the relative risk of
a firm’s cash flow is likely to vary over the business cycle. As indicated by Harvey (1989), Shanken
(1990), Jagannathan and Wang (1996), Ferson and Harvey (1991, 1999), and Lettau and Ludvigson
(2001), betas and expected returns will in general depend on the nature of the information available
at any given point in time and vary over time.
The conditional version of the CAPM imposes restriction that conditionally expected returns
on assets are linearly related to the conditionally expected return on the market portfolio in excess of
the risk-free rate. The coefficient in the linear relation is the asset’s conditional beta or the ratio of
the conditional covariance of the asset’s return with the market to the conditional variance of the
market:
Cov( Ri ,t +1 , Rm ,t +1 | Ω t )
E ( Ri ,t +1 | Ω t ) = E ( Rm ,t +1 | Ω t ) (16)
Var ( Rm ,t +1 | Ω t )
 22

where E ( Ri ,t +1 | Ω t ) is the conditional expected excess return of asset i, E ( Rm,t +1 | Ω t ) is the

Cov ( Ri ,t +1 , Rm ,t +1 | Ω t )
conditional expected excess return of the market portfolio, β i ,t +1 = is the
Var ( Rm ,t +1 | Ω t )

conditional market beta of asset i, and Ω t denotes the information set at time t.
We now rewrite equation (16) to simplify the follow-up expressions:
E (Ri ,t +1 | Ω t ) = Am ,t +1 ⋅ β i ,t +1 , (17)

where Am ,t +1 = E (Rm,t +1 | Ω t ) is the time t+1 conditional expected market risk premium.

Taking the unconditional expectation of both sides of equation (17), we obtain the
unconditional implication of the conditional CAPM:
E [Ri ,t +1 ] = Am ⋅ β i + Cov ( Am,t +1 , β i ,t +1 ) (18)

where Cov( Am ,t +1 , β i ,t +1 ) denotes the unconditional covariance, E [Am ,t +1 ] = Am and E [β i ,t +1 ] = β i are

the unconditional means of the corresponding conditional estimates.

Notice that the last term in equation (18) depends only on the part of the conditional beta
that is in the linear span of the market risk premium. This motivates Jagannathan and Wang (1996)
to decompose the conditional beta of any asset i into two orthogonal components by regressing the
conditional beta on the market risk premium. For each asset i, we run the following regression:
β i ,t +1 = β i + λi ( Am,t +1 − Am ) + u i ,t +1 , (19)

where λi = Cov( Am ,t +1 , β i ,t +1 ) / Var ( Am ,t +1 ) is the unconditional market beta-premium sensitivity that

measures the sensitivity of conditional beta to the market risk premium.

Substituting (19) into (18) gives:
E [Ri ,t +1 ] = Am ⋅ β i + λi ⋅ Var ( Am ,t +1 ) (20)

Hence, cross-sectionally, the unconditional expected excess return on any asset i is a linear function
of the unconditional average of its conditional market beta ( β i ) and its unconditional market beta-

premium sensitivity ( λi ). Equation (20) implies that stocks with higher expected betas have higher
unconditional expected returns. Likewise, stocks with betas that are prone to vary with the market
risk premium and hence less stable over the business cycle also have higher unconditional expected
returns. Hence, the one-factor conditional CAPM leads to a two-factor model for unconditional
expected returns.
 23

A complete test of the conditional CAPM specification requires estimation of expected beta
( β i ) and beta-premium sensitivity ( λi ). In this paper, we use the average conditional beta estimates

obtained from AR(1), MA(1), and GARCH-in-mean specifications as a proxy for β i . We estimate

beta-premium sensitivity λi using the lagged market return as a proxy for the expected market risk

premium, i.e., λi = Cov( Rm ,t , β i ,t +1 ) / Var ( Rm ,t ) , where the lagged market return, Rm,t , is used as a

proxy for the time t+1 conditional expected market risk premium, Am,t +1 = E (Rm ,t +1 | Ω t ) = Rm,t .

For each month, we run the following cross-sectional Fama-MacBeth regressions:

Ri ,t = γ 0,t + γ 1,t β i AR + γ 2,t ⋅ λiAR + ε i ,t , (21)

Ri ,t = γ 0,t + γ 1,t β i MA + γ 2,t ⋅ λiMA + ε i ,t (22)

Ri ,t = γ 0,t + γ 1,t β i GARCH + γ 2,t ⋅ λGARCH

i + ε i ,t (23)

where β i AR , β i MA , and β i GARCH are the time-series average of β iAR

,t |t −1 , β i ,t |t −1 , and β i ,t |t −1 ,
MA GARCH

respectively. λiAR , λiMA , and λGARCH

i are obtained from the regression of β iAR
,t |t −1 , β i ,t |t −1 , and β i ,t |t −1
MA GARCH

on Rm,t , respectively. Rm ,t is proxied by the lagged return on the CRSP value-weighted index.

Table XV presents the time-series averages of the slope coefficients and their Newey-West
adjusted t-statistics (in parentheses) from the monthly cross-sectional Fama-MacBeth regressions of
stock returns on their average conditional beta and beta premium sensitivity. The average slope on
β i AR , β i MA , and β i GARCH is about 0.6220, 0.6189, and 0.5705 with the Newey-West t-statistic of
2.89, 2.85, and 2.67, respectively. But, the average slope coefficients on beta premium sensitivity are
economically and statistically insignificant for all specifications of the conditional beta measures. The
results indicate significantly positive relation between average conditional beta and the cross-section
of expected returns within the conditional CAPM framework.

VII. Conclusion
This paper investigates the cross-sectional relation between conditional betas and expected
stock returns for the sample period of July 1963 – December 2004. First, we use daily returns within
a month to compute realized beta for each stock trading at the NYSE, AMEX, and NASDAQ and
then propose three alternative specifications of expected future beta based on the past information
 24

on realized beta. Specifically, we use autoregressive, moving average, and GARCH-in-mean models
to obtain time-varying conditional betas for each stock.
For each specification of conditional beta, we find that average portfolio returns increase
almost monotonically when moving from low-beta to high-beta portfolios. The portfolio-level
analyses and the firm-level cross-sectional regressions indicate that the positive relation between the
conditional betas and the cross-section of average returns is economically and statistically significant.
For the NYSE/AMEX/NASDAQ sample, the average return difference between high-β and low-β
portfolios is in the range of 0.89% to 1.01% per month depending on the time-varying specification
of conditional beta. To check whether our findings are driven by small, illiquid, and low-price stocks,
we exclude the AMEX and NASDAQ stocks and form the beta portfolios by sorting only the
NYSE stocks based on the conditional betas. The results indicate that excluding the AMEX and
NASDAQ sample has almost no effect on our original findings. We also control for the well-known
cross-sectional effects including size, book-to-market, liquidity, and momentum. After controlling
for these effects, we estimate the cross-sectional beta-premium to be in the range of 0.86% to 1.46%
per month. These results are robust across different measures of conditional beta.
 25

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 28
Table I. Time-Series Mean and Standard Deviation of Realized and Conditional Betas
This table presents the percentiles of the time-series mean and standard deviation of realized and conditional betas for the sample period of July 1963-December
2004. In Panel A, realized beta for each stock trading at NYSE/AMEX/NASDAQ is computed using daily returns over the previous month without lagged
market return. In Panel B, realized beta is computed using daily returns over the previous month with the lagged market return. The CRSP value-weighted index
is used as a proxy for the market portfolio. Conditional betas are estimated based on the AR(1), MA(1), and GARCH-in-mean models:

AR(1): β t = a 0 + a1 β t −1 + ε t , E ( β t | Ω t −1 ) = β tAR
|t −1 = aˆ 0 + aˆ1 β t −1 , E (ε t2 ) = σ 2
MA(1): β t = b0 + b1ε t −1 + ε t , E ( β t | Ω t −1 ) = β tMA ˆ ˆ
|t −1 = b0 + b1ε t −1 , E (ε t ) = σ
2 2

GARCH-in-mean: β t = c 0 + c1σ t2|t −1 + ε t , E ( β t | Ω t −1 ) = β tGARCH

|t −1 = cˆ0 + cˆ1σ t2|t −1 , E (ε t2 | Ω t −1 ) = σ t2|t −1 = γ 0 + γ 1ε t2−1 + γ 2σ t2−1

Panel A. Realized Beta is Estimated without the Lagged Market Return

MEAN 1% 5% 10% 20% 30% 40% 50% 60% 70% 80% 90% 95% 99%
β t
realized
-0.1426 0.0347 0.1112 0.2325 0.3503 0.4610 0.5642 0.6862 0.8163 0.9777 1.2420 1.4954 2.0480

STD DEV 1% 5% 10% 20% 30% 40% 50% 60% 70% 80% 90% 95% 99%
β t
realized
0.3929 0.5348 0.6360 0.7841 0.9236 1.0641 1.2175 1.3879 1.5970 1.8609 2.3190 2.8373 4.2165
β AR
t |t −1 0.0019 0.0111 0.0228 0.0463 0.0701 0.0965 0.1255 0.1590 0.2009 0.2615 0.3687 0.4846 0.8120
β MA
t |t −1 0.0020 0.0109 0.0220 0.0442 0.0657 0.0891 0.1154 0.1439 0.1830 0.2369 0.3378 0.4527 0.8169
β GARCH
t |t −1 0.0014 0.0101 0.0164 0.0454 0.0747 0.1071 0.1431 0.1880 0.2435 0.3251 0.4693 0.6275 1.1644

Panel B. Realized Beta is Estimated with the Lagged Market Return

MEAN 1% 5% 10% 20% 30% 40% 50% 60% 70% 80% 90% 95% 99%
β t
realized
-0.1450 0.0692 0.1744 0.3217 0.4587 0.5885 0.7111 0.8392 0.9726 1.1352 1.3826 1.6126 2.2350

STD DEV 1% 5% 10% 20% 30% 40% 50% 60% 70% 80% 90% 95% 99%
β t
realized
0.5428 0.7126 0.8439 1.0454 1.2325 1.4229 1.6222 1.8551 2.1360 2.4868 3.0675 3.6365 5.4468
β AR
t |t −1 0.0165 0.0395 0.0596 0.0920 0.1225 0.1539 0.1885 0.2312 0.2845 0.3641 0.4991 0.6627 1.1396
β MA
t |t −1 0.0026 0.0117 0.0234 0.0472 0.0723 0.0976 0.1260 0.1609 0.2071 0.2737 0.3971 0.5455 1.0561
β GARCH
t |t −1 0.0059 0.0101 0.0221 0.0461 0.0802 0.1189 0.1635 0.2201 0.2877 0.3853 0.5551 0.7714 1.5448
 29
Table II. Performance of Lagged Realized and Conditional Betas in Predicting Future Realized Beta

This table presents the percentiles of the R2 values from the regression of one-month-ahead realized betas on the lagged realized and conditional betas for the
sample period of July 1963 to December 2004. In Panel A, realized beta for each stock trading at NYSE/AMEX/NASDAQ is computed using daily returns over
the previous month without lagged market return. In Panel B, realized beta is computed using daily returns over the previous month with the lagged market
return. The CRSP value-weighted index is used as a proxy for the market portfolio. Conditional betas are estimated based on the AR(1), MA(1), and GARCH-in-
mean models. The following OLS regressions are run to obtain the R2 values:

β trealized = d 0 + d1 β trealized
−1 + εt
β trealized = d 0 + d 1 β tAR
|t −1 + ε t

β trealized = d 0 + d 1 β tMA
|t −1 + ε t

β trealized = d 0 + d1 β tGARCH
|t −1 + εt

Panel A. Realized Beta is Estimated without the Lagged Market Return

R2 1% 5% 10% 20% 30% 40% 50% 60% 70% 80% 90% 95% 99%
β trealized
−1 0.01% 0.11% 0.22% 0.69% 1.18% 1.94% 3.22% 4.66% 6.89% 9.94% 13.26% 17.67% 26.82%
β tAR
|t −1 0.74% 2.04% 2.87% 4.58% 6.16% 7.88% 10.31% 13.12% 15.77% 19.24% 23.90% 27.76% 33.82%

β tMA
|t −1 0.63% 1.94% 2.67% 4.48% 5.95% 7.65% 9.98% 12.54% 15.39% 18.72% 23.26% 26.70% 32.32%
β tGARCH
|t −1 1.14% 2.46% 3.33% 4.93% 6.75% 8.90% 11.01% 13.80% 16.70% 20.67% 24.88% 27.88% 33.87%

Panel B. Realized Beta is Estimated with the Lagged Market Return

R2 1% 5% 10% 20% 30% 40% 50% 60% 70% 80% 90% 95% 99%
β trealized
−1 0.01% 0.03% 0.08% 0.22% 0.46% 0.81% 1.21% 1.73% 2.65% 4.12% 6.63% 9.54% 16.76%

β tAR
|t −1 1.29% 2.28% 3.12% 4.22% 5.29% 6.10% 7.13% 8.38% 10.20% 12.66% 16.20% 19.60% 24.77%
β tMA
|t −1 1.29% 2.35% 3.14% 4.15% 5.19% 6.04% 7.13% 8.40% 10.19% 12.50% 15.92% 19.16% 24.00%
β tGARCH
|t −1 1.17% 2.12% 3.09% 4.23% 5.04% 6.02% 7.10% 8.31% 10.50% 12.58% 16.99% 19.73% 24.62%
 30

Table III. Equal-Weighted Returns on Portfolios Sorted by Realized and Conditional Beta
Equal-weighted decile portfolios are formed every month from July 1963 to December 2004 by sorting the NYSE/AMEX/NASDAQ stocks based on
realized and conditional beta. In Panel A, realized beta for each stock is computed using daily returns over the previous month without lagged market
return. In Panel B, realized beta is computed using daily returns over the previous month with the lagged market return. The CRSP value-weighted
index is used as a proxy for the market portfolio. Portfolio 1 (10) is the portfolio of stocks with the lowest (highest) realized or conditional betas. The
row “High-Low” refers to the difference in monthly returns between portfolios 10 and 1. The row “Alpha” reports Jensen’s alpha with respect to the
Fama-French (1993) model. Newey-West (1987) adjusted t-statistics are reported in parentheses.

AR(1): β t = a 0 + a1 β t −1 + ε t , E ( β t | Ω t −1 ) = β tAR
|t −1 = aˆ 0 + aˆ1 β t −1 , E (ε t2 ) = σ 2
MA(1): β t = b0 + b1ε t −1 + ε t , E ( β t | Ω t −1 ) = β tMA ˆ ˆ
|t −1 = b0 + b1ε t −1 , E (ε t ) = σ
2 2

GARCH-in-mean: β t = c 0 + c1σ t2|t −1 + ε t , E ( β t | Ω t −1 ) = β tGARCH

|t −1 = cˆ0 + cˆ1σ t2|t −1 , E (ε t2 | Ω t −1 ) = σ t2|t −1 = γ 0 + γ 1ε t2−1 + γ 2σ t2−1

Panel A. Realized Beta is Estimated without the Lagged Market Return

β trealized
−1
β tAR
|t −1 β tMA
|t −1 β tGARCH
|t −1

Average Average Average Average Average Average Average Average

Decile
Return Beta Return Beta Return Beta Return Beta
1 Low β 1.56 -1.65 1.09 0.08 1.07 0.02 1.11 0.00
2 1.36 -1.37 1.21 0.24 1.21 0.25 1.15 0.23
3 1.38 -0.01 1.30 0.37 1.31 0.37 1.27 0.36
4 1.38 0.23 1.41 0.48 1.36 0.48 1.29 0.47
5 1.35 0.47 1.37 0.58 1.41 0.59 1.38 0.58
6 1.41 0.72 1.44 0.69 1.46 0.70 1.41 0.69
7 1.34 1.01 1.51 0.81 1.46 0.82 1.49 0.82
8 1.27 1.37 1.53 0.96 1.54 0.96 1.51 0.97
9 1.25 1.91 1.58 1.16 1.60 1.15 1.67 1.18
10 High β 1.07 3.40 1.83 1.55 1.85 1.62 2.03 1.71
-0.49 0.74 0.78 0.92
High–Low
(-2.53) (2.33) (2.47) (2.65)
-0.48 0.50 0.53 0.60
Alpha
(-2.85) (2.17) (2.33) (2.60)
 31

Panel B. Realized Beta is Estimated with the Lagged Market Return

β trealized
−1
β tAR
|t −1 β tMA
|t −1 β tGARCH
|t −1

Average Average Average Average Average Average Average Average

Decile
Return Beta Return Beta Return Beta Return Beta
1 Low β 1.44 -2.25 1.13 0.03 1.13 0.05 1.10 0.02
2 1.32 -0.55 1.15 0.33 1.15 0.33 1.19 0.32
3 1.33 -0.08 1.27 0.47 1.25 0.48 1.25 0.46
4 1.39 0.24 1.38 0.60 1.38 0.60 1.28 0.59
5 1.42 0.53 1.36 0.71 1.37 0.72 1.39 0.71
6 1.41 0.85 1.41 0.83 1.42 0.83 1.40 0.83
7 1.36 1.21 1.49 0.95 1.49 0.95 1.44 0.95
8 1.38 1.65 1.57 1.08 1.58 1.08 1.55 1.09
9 1.25 2.32 1.62 1.27 1.64 1.26 1.69 1.29
10 High β 1.08 4.25 2.02 1.74 2.00 1.70 2.11 1.83
-0.33 0.89 0.87 1.01
High–Low
(-1.92) (2.66) (2.54) (2.83)
-0.35 0.63 0.60 0.71
Alpha
(-2.36) (2.76) (2.62) (3.06)
 32

Table IV. Equal-Weighted Returns on Portfolios Sorted by GARCH-in-Mean Beta After Controlling for Size and BM

In Panel A, we first form decile portfolios of NYSE/AMEX/NASDAQ stocks ranked based on their market capitalizations. Then, within each size decile, we sort
stocks into decile portfolios ranked based on GARCH-in-mean beta so that decile 1 (10) contains stocks with the lowest (highest) market beta. The column labeled
“Average Returns” averages across the 10 size deciles to produce decile portfolios with dispersion in market beta and with near-identical levels of firm size and thus
these decile beta portfolios control for differences in size. In Panel B, we first form decile portfolios of NYSE/AMEX/NASDAQ stocks ranked based on their
book-to-market ratios (BM). Then, within each BM decile, we sort stocks into decile portfolios ranked based on GARCH-in-mean beta so that decile 1 (10) contains
stocks with the lowest (highest) market beta. The column labeled “Average Returns” averages across the 10 BM deciles to produce decile portfolios with dispersion
in market beta and with near-identical levels of BM and thus these decile beta portfolios control for differences in book-to-market.

Panel A. Equal-Weighted Returns on Beta-Portfolios After Controlling for Size

Average
Small Size Size-2 Size-3 Size-4 Size-5 Size-6 Size-7 Size-8 Size-9 Big Size t-statistic
Returns
1 Low β 2.85 0.61 0.48 0.63 0.68 0.78 0.88 0.83 0.84 0.80 0.94 5.07
2 2.12 0.98 1.03 0.83 0.88 0.86 1.11 1.00 1.05 0.88 1.07 5.26
3 2.63 0.98 1.06 0.86 0.81 0.84 0.99 1.10 0.96 0.93 1.12 4.76
4 2.40 1.31 1.13 1.05 0.96 0.98 1.12 1.07 1.03 0.99 1.20 4.67
5 2.93 1.29 1.20 1.19 1.13 1.12 1.24 1.24 1.01 1.02 1.34 4.72
6 3.18 1.51 1.17 1.18 1.15 1.18 1.16 1.13 1.06 0.97 1.37 4.58
7 3.39 1.79 1.55 1.29 1.17 1.17 1.19 1.11 1.28 0.99 1.49 4.67
8 3.49 1.83 1.62 1.65 1.53 1.40 1.27 1.34 1.11 1.01 1.63 4.54
9 4.46 2.18 1.88 1.63 1.72 1.69 1.28 1.26 1.28 1.00 1.84 4.56
10 High β 5.36 3.04 2.31 2.23 2.05 2.13 2.03 1.75 1.51 1.08 2.35 4.55

High β – Low β 1.41 3.48

 33

Panel B. Equal-Weighted Returns on Beta-Portfolios After Controlling for Book-to-Market

Average
Low BM BM-2 BM-3 BM-4 BM-5 BM-6 BM-7 BM-8 BM-9 High BM t-statistic
Returns
1 Low β 0.35 0.40 0.77 0.86 0.82 1.15 1.21 1.42 1.35 1.91 1.02 4.55
2 0.19 0.65 0.72 0.90 1.03 1.05 1.22 1.49 1.31 1.95 1.05 4.62
3 0.51 0.79 0.93 1.04 1.02 1.16 1.19 1.32 1.60 1.83 1.14 4.79
4 0.59 0.70 1.11 1.10 1.05 1.22 1.47 1.49 1.90 2.28 1.29 5.14
5 0.69 1.01 1.19 1.11 1.13 1.27 1.45 1.57 1.84 2.13 1.34 5.04
6 0.45 0.92 0.90 1.20 1.20 1.36 1.57 1.64 1.71 1.85 1.28 4.69
7 0.85 1.09 1.39 1.31 1.27 1.37 1.52 1.68 1.79 2.22 1.45 4.87
8 1.00 1.19 1.34 1.40 1.17 1.67 1.54 1.70 1.91 2.26 1.52 4.76
9 1.03 1.39 1.34 1.58 1.63 1.73 1.89 2.05 2.43 2.43 1.75 4.93
10 High β 1.64 1.62 1.68 1.90 2.04 2.07 2.44 2.31 2.94 3.16 2.18 4.80

High β – Low β 1.16 3.69

 34

Table V. Average Return Differences and FF-3 Alphas within each Size and BM Deciles

In Panel A, we first form decile portfolios of NYSE/AMEX/NASDAQ stocks ranked based on their market
capitalizations. Then, within each size decile, we sort stocks into decile portfolios ranked based on conditional beta so that
decile 1 (10) contains stocks with the (lowest) highest market beta. Average return differences and alphas along with their
Newey-West (1987) adjusted t-statistics in parentheses are reported for each size decile. In Panel B, we first form decile
portfolios of NYSE/AMEX/NASDAQ stocks ranked based on their book-to-market ratios (BM). Then, within each BM
decile, we sort stocks into decile portfolios ranked based on GARCH-in-mean beta so that decile 1 (10) contains stocks
with the lowest (highest) market beta. Average return differences and alphas along with their Newey-West (1987) adjusted
t-statistics in parentheses are reported for each BM decile.

Panel A. Average Return Differences and FF-3 Alphas within Size Deciles

β tAR
|t −1 β tMA
|t −1 β tGARCH
|t −1

Decile High β – Low β Alpha High β – Low β Alpha High β – Low β Alpha
2.49 2.02 2.57 2.06 2.50 2.02
Small Size
(5.79) (5.54) (6.09) (6.05) (5.89) (5.35)
2.17 1.65 2.22 1.69 2.43 1.83
Size-2
(4.94) (4.55) (5.01) (4.67) (5.34) (5.14)
1.92 1.40 1.88 1.33 1.83 1.27
Size-3
(4.00) (3.55) (3.88) (3.36) (3.82) (3.40)
1.67 1.25 1.68 1.23 1.60 1.05
Size-4
(3.65) (3.48) (3.57) (3.44) (3.46) (3.44)
1.54 1.14 1.52 1.13 1.37 0.94
Size-5
(3.46) (3.56) (3.40) (3.57) (3.06) (3.05)
1.49 1.17 1.51 1.16 1.35 0.93
Size-6
(3.25) (3.59) (3.21) (3.57) (2.83) (2.69)
1.19 1.01 1.08 0.88 1.15 0.88
Size-7
(2.68) (3.26) (2.39) (2.87) (2.56) (2.91)
0.72 0.64 0.82 0.73 0.92 0.87
Size-8
(1.67) (2.34) (1.87) (2.64) (2.09) (3.05)
0.60 0.63 0.65 0.67 0.67 0.65
Size-9
(1.33) (2.09) (1.39) (2.13) (1.45) (2.13)
0.24 0.42 0.24 0.43 0.28 0.50
Big Size
(0.60) (1.58) (0.60) (1.64) (0.68) (1.91)
 35

Panel B. Average Return Differences and FF-3 Alphas within Book-to-Market Deciles

β tAR
|t −1 β tMA
|t −1 β tGARCH
|t −1

Decile High β – Low β Alpha High β – Low β Alpha High β – Low β Alpha
1.50 1.60 1.49 1.54 1.29 1.36
Low BM
(3.75) (4.59) (3.74) (4.50) (3.27) (4.21)
1.27 1.27 1.31 1.33 1.22 1.19
BM-2
(3.44) (3.83) (3.66) (4.12) (3.28) (3.57)
0.89 0.80 0.82 0.70 0.91 0.73
BM-3
(2.58) (2.71) (2.37) (2.37) (2.61) (2.67)
0.98 0.68 0.93 0.65 1.03 0.67
BM-4
(2.90) (2.59) (2.76) (2.41) (3.06) (2.52)
1.18 0.71 1.22 0.75 1.22 0.79
BM-5
(3.48) (2.71) (3.48) (2.73) (3.22) (2.65)
0.90 0.44 0.84 0.39 0.92 0.37
BM-6
(2.90) (1.73) (2.66) (1.56) (2.83) (1.53)
0.90 0.47 0.90 0.46 1.24 0.81
BM-7
(2.46) (1.53) (2.39) (1.45) (3.08) (2.38)
0.82 0.41 0.74 0.30 0.89 0.37
BM-8
(2.27) (1.39) (2.15) (1.07) (2.38) (1.25)
1.51 1.01 1.41 0.94 1.59 1.14
BM-9
(4.09) (3.25) (3.86) (2.98) (4.10) (3.52)
0.60 -0.15 0.49 -0.24 1.25 0.59
High BM
(1.62) (-0.46) (1.32) (-0.73) (3.21) (1.75)
 36
Table VI. Firm-Level Cross-Sectional Regressions
Panel A presents the firm-level cross-sectional regression results for the NYSE/AMEX/NASDAQ stocks for the
sample period of July 1963 to December 2004. The monthly conditional betas are estimated based on the AR(1),
MA(1), and GARCH-in-mean specification of the realized beta measures. Realized beta of each stock is calculated using
daily data over the previous month with the lagged market return. log MEt −1 is the last month’s log market
capitalization (size), and log( BE t −1 / ME t −1 ) is the last fiscal year’s log book-to-market ratio. The time-series average
slope coefficients are reported in each row. Newey-West (1987) adjusted t-statistics are given in parentheses. The last
column presents the average R2 values.

Panel A. Standard Fama-MacBeth Regressions

β trealized
−1 β tAR
|t −1 β tMA
|t −1 β tGARCH
|t −1 log ME t −1 log( BE t −1 / ME t −1 ) R2
–0.0678
1.04%
(–1.19)
0.4443
2.06%
(2.09)
0.4890
2.02%
(2.26)
0.4565
2.13%
(2.32)
-0.2373
1.81%
(-4.75)
0.4185
1.00%
(5.98)
-0.2029 0.2396
2.69%
(-3.83) (3.21)
–0.0124 -0.2229
2.79%
(–0.21) (-4.18)
0.7985 -0.2907
4.34%
(3.07) (-4.69)
0.8063 -0.2901
4.31%
(3.09) (-4.68)
0.8010 -0.2869
4.27%
(3.05) (-4.52)
–0.0357 0.4328
1.85%
(–0.68) (6.67)
0.6694 0.4721
2.83%
(3.34) (7.39)
0.6796 0.4718
2.79%
(3.36) (7.37)
0.6470 0.4771
2.89%
(3.41) (7.44)
0.0045 -0.1861 0.2765
3.50%
(0.08) (-3.31) (4.03)
0.8967 -0.2587 0.2745
4.70%
(3.65) (-4.01) (4.29)
0.9041 -0.2579 0.2740
4.70%
(3.66) (-4.00) (4.28)
0.8929 -0.2526 0.2872
4.87%
(3.60) (-3.86) (4.62)
 37

Table VI (continued)
Panel B presents the firm-level cross-sectional regression results for the NYSE/AMEX/NASDAQ stocks after
correcting for errors-in-variables problem. Entries in Panel B are the intercepts and the Newey-West (1987) adjusted t-
statistics (in parentheses) from the time-series regressions of the monthly slope coefficients on the portfolio returns that
mimic beta-related risk factor.

Panel B. Univariate Fama-MacBeth Regressions After Correcting for Errors-in-Variables Problem

CRSP breakpoint NYSE breakpoint

-0.0471 -0.0680
Realized Beta
(-1.0994) (-1.9365)
0.2553 0.2525
AR(1) Beta
(2.2987) (2.8266)
0.2260 0.2521
MA(1) Beta
(2.0121) (2.8091)
0.2884 0.3122
GARCH-in-mean Beta
(2.6727) (3.6133)
 38

Table VII. Average Return Differences and Alphas on Portfolios Sorted by Conditional Beta

Equal-weighted 20, 50, and 100 portfolios are formed every month from July 1963 to December 2004 by sorting the
NYSE/AMEX/NASDAQ stocks based on realized and conditional beta. The row “High-Low” refers to the difference in
monthly returns between portfolios either 20 and 1, or 50 and 1, or 100 and 1. The row “Alpha” reports Jensen’s alpha
with respect to the Fama-French (1993) model. Newey-West (1987) adjusted t-statistics are reported in parentheses.

β tAR
|t −1 β tMA
|t −1 β tGARCH
|t −1

20 Beta 50 Beta 100 Beta 20 Beta 50 Beta 100 Beta 20 Beta 50 Beta 100 Beta
Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio
1.10 1.21 1.13 1.09 1.01 1.07 1.23 1.22 1.11
High–Low
(2.93) (2.88) (2.32) (2.90) (2.50) (2.21) (3.17) (2.92) (2.40)
0.83 0.93 0.86 0.81 0.71 0.80 0.92 0.90 0.79
Alpha
(3.09) (2.66) (2.02) (3.02) (2.14) (1.94) (3.52) (2.86) (2.06)
 39

Table VIII. Portfolio-Level Cross-Sectional Regressions

This table presents the portfolio-level cross-sectional regression results for the 10, 20, 50, and 100 beta
portfolios for the sample period of July 1963 to December 2004. A portfolio’s average beta is computed as
the equal-weighted average of the conditional betas of all stocks in that portfolio. The monthly conditional
beta of each stock is estimated based on the AR(1), MA(1), and GARCH-in-mean specification of the realized
beta measure. Realized beta of each stock is calculated using daily data over the previous month with the
lagged market return. The time series averages of the slope coefficients from the regression of average
portfolio returns on the average portfolio beta are presented in each row. Newey-West (1987) adjusted t-
statistics are reported in parentheses.

Portfolios β tAR
|t −1 β tMA
|t −1 β tGARCH
|t −1 R2
0.4427
10 Beta Portfolio 58.30%
(2.25)
0.4694
10 Beta Portfolio 57.77%
(2.37)
0.5310
10 Beta Portfolio 59.27%
(2.61)
0.4415
20 Beta Portfolio 47.95%
(2.25)
0.4694
20 Beta Portfolio 47.52%
(2.38)
0.5247
20 Beta Portfolio 48.69%
(2.60)
0.4334
50 Beta Portfolio 34.93%
(2.24)
0.4635
50 Beta Portfolio 34.72%
(2.37)
0.5202
50 Beta Portfolio 35.62%
(2.62)
0.4325
100 Beta Portfolio 25.68%
(2.24)
0.4625
100 Beta Portfolio 25.53%
(2.37)
0.5096
100 Beta Portfolio 26.21%
(2.59)
 40
Table IX. Long Term Predictive Power of Conditional Beta

This table presents the equal-weighted average returns, average return differences, and alphas from the 1-month to 12-month ahead predictability of stock
returns. Equal-weighted decile portfolios are formed every month from July 1963 to December 2004 by sorting the NYSE/AMEX/NASDAQ stocks based
on the GARCH-in-mean beta estimates conditional on time t-1 to t-12. Portfolio 1 (10) is the portfolio of stocks with the lowest (highest) realized or expected
betas. The row “High-Low” refers to the difference in monthly returns between portfolios 10 and 1. The row “Alpha” reports Jensen’s alpha with respect to
the Fama-French (1993) model. Newey-West (1987) adjusted t-statistics are reported in parentheses.

Decile β tGARCH
|t −1 β tGARCH
−1|t − 2 β tGARCH
− 2|t −3 β tGARCH
−3|t − 4 β tGARCH
− 4|t −5 β tGARCH
−5|t − 6 β tGARCH
− 6|t − 7 β tGARCH
− 7|t −8 β tGARCH
−8|t −9 β tGARCH
−9|t −10 β tGARCH
−10|t −11 β tGARCH
−11|t −12

1 Low β 1.10 1.11 1.12 1.12 1.12 1.16 1.16 1.17 1.19 1.21 1.21 1.22
2 1.19 1.16 1.18 1.22 1.25 1.20 1.20 1.20 1.21 1.23 1.24 1.25
3 1.25 1.24 1.22 1.26 1.22 1.23 1.25 1.27 1.25 1.24 1.27 1.27
4 1.28 1.29 1.29 1.23 1.31 1.30 1.31 1.29 1.30 1.28 1.33 1.32
5 1.39 1.41 1.38 1.41 1.37 1.42 1.33 1.37 1.37 1.40 1.36 1.39
6 1.40 1.37 1.41 1.43 1.44 1.41 1.48 1.44 1.43 1.43 1.44 1.44
7 1.44 1.46 1.48 1.42 1.44 1.43 1.42 1.44 1.42 1.42 1.40 1.38
8 1.55 1.55 1.52 1.56 1.56 1.58 1.57 1.53 1.53 1.55 1.56 1.54
9 1.69 1.69 1.69 1.66 1.67 1.64 1.64 1.65 1.67 1.64 1.66 1.67
10 High β 2.11 2.06 2.05 2.04 2.04 2.03 2.00 1.98 1.96 1.98 1.97 1.97
1.01 0.95 0.93 0.92 0.92 0.87 0.84 0.81 0.77 0.77 0.76 0.75
High – Low
(2.83) (2.69) (2.60) (2.55) (2.54) (2.42) (2.33) (2.23) (2.13) (2.16) (2.12) (2.09)
0.71 0.64 0.62 0.60 0.61 0.56 0.53 0.49 0.46 0.44 0.43 0.43
Alpha
(3.06) (2.82) (2.69) (2.58) (2.63) (2.41) (2.28) (2.10) (1.96) (1.93) (1.88) (1.88)
 41

Table X. Average Returns on Beta Portfolios After Controlling for Liquidity and Momentum

This table presents the equal-weighted average returns and average return differences on beta portfolios after
controlling for liquidity and momentum. We first form decile portfolios of NYSE/AMEX/NASDAQ stocks ranked
based on their illiquidity, dollar trading volume, past average 6-month (MOM6), and past average 12-month
(MOM12) returns. Then, within each illiquidity, volume, MOM6, and MOM12 decile, we sort stocks into decile
portfolios ranked based on GARCH-in-mean beta so that decile 1 (10) contains stocks with the lowest (highest)
market beta. The average returns reported below are the averages across the 10 illiquidity, volume, Mom_6, and
Mom_12 deciles to produce decile portfolios with dispersion in market beta and with near-identical levels of
illiquidity, volume, Mom_6, and Mom_12. Newey-West (1987) adjusted t-statistics are reported in parentheses.

Decile Illiquidity Volume MOM6 MOM12

0.99 0.92 0.86 1.05
1 Low β
(5.23) (4.92) (3.89) (4.82)
1.13 1.05 0.94 1.18
2
(5.30) (5.13) (3.99) (5.10)
1.18 1.09 1.02 1.22
3
(5.06) (4.72) (4.19) (5.17)
1.19 1.19 1.16 1.34
4
(4.63) (4.70) (4.53) (5.34)
1.29 1.32 1.30 1.53
5
(4.74) (4.82) (5.02) (6.01)
1.38 1.33 1.36 1.55
6
(4.61) (4.51) (5.00) (5.71)
1.37 1.45 1.39 1.52
7
(4.44) (4.51) (4.82) (5.43)
1.57 1.58 1.45 1.60
8
(4.44) (4.43) (4.61) (5.21)
1.75 1.83 1.57 1.67
9
(4.36) (4.51) (4.47) (4.83)
2.20 2.38 1.85 1.91
10 High β
(4.33) (4.58) (4.11) (4.34)
1.20 1.46 0.99 0.86
High – Low
(3.05) (3.68) (2.89) (2.74)
 42

Table XI. Firm-Level Cross-Sectional Regressions with Size, BM, Liquidity, and Momentum
This table presents the firm-level cross-sectional regression results for the NYSE/AMEX/NASDAQ stocks for the
sample period of July 1963 to December 2004. The monthly conditional beta is estimated based on the GARCH-in-
mean specification. ILLIQt −1 is the last month’s illiquidity measure of each stock, VOLt −1 is the last month’s dollar
trading volume, MOM 6 t −1 is the past 6-month average return, MOM 12 t −1 is the past 12-month average return,
log ME t −1 is the last month’s log market capitalization (size), and log( BE t −1 / ME t −1 ) is the last fiscal year’s log
book-to-market ratio. The time-series average slope coefficients are reported in each row. Newey-West (1987)
adjusted t-statistics are given in parentheses. The last column presents the average R2 values.

β tGARCH
|t −1 ILLIQt −1 VOLt −1 MOM 6 t −1 MOM 12 t −1 log MEt −1 log( BEt −1 / MEt −1 ) R2
0.5092 6.4938
2.87%
(2.45) (3.41)
0.5183 -6.3239
2.64%
(2.46) (-2.57)
0.4123 -3.6474
3.45%
(2.06) (-2.33)
0.4058 1.3056
3.53%
(2.12) (0.61)
0.6453 3.1506 -4.6308 -0.1480 0.3141
6.27%
(3.00) (2.20) (-3.25) (-2.51) (4.46)
0.6609 3.2395 -0.0913 -0.1659 0.3065
6.33%
(3.19) (2.22) (-0.05) (-2.84) (4.55)
0.6235 -0.0044 -4.7820 -0.1893 0.3215
6.14%
(2.92) (-0.01) (-3.41) (-2.98) (4.58)
0.6361 0.1139 -0.3081 -0.2087 0.3136
6.20%
(3.09) (0.08) (-0.16) (-3.31) (4.67)
 43

Table XII. Equal-Weighted Returns on Portfolios of NYSE Stocks Sorted by Conditional Beta

Equal-weighted decile portfolios are formed every month from July 1963 to December 2004 by sorting the NYSE
stocks based on the conditional GARCH-in-mean beta. Portfolio 1 (10) is the portfolio of stocks with the lowest
(highest) realized or conditional betas. The row “High-Low” refers to the difference in monthly returns between
portfolios 10 and 1. The row “Alpha” reports Jensen’s alpha with respect to the Fama-French (1993) model.
Newey-West (1987) adjusted t-statistics are reported in parentheses.

Average Return Average Return Average Return

Decile
(Univariate Sort) (After controlling for Size) (After controlling for BM)
1 Low β 1.11 1.06 1.11
2 1.21 1.20 1.15
3 1.34 1.24 1.22
4 1.36 1.32 1.25
5 1.35 1.37 1.33
6 1.35 1.37 1.37
7 1.45 1.45 1.30
8 1.51 1.56 1.46
9 1.54 1.65 1.58
10 High β 1.97 1.90 1.89
0.86 0.84 0.78
High – Low
(2.79) (2.81) (2.94)
0.37 0.43 0.34
Alpha
(2.44) (2.87) (2.23)
 44

Table XIII. Equal-Weighted Portfolios Using NYSE Breakpoints and Controlling for Microstructure Effects
Equal-weighted decile portfolios are formed every month from July 1963 to December 2004 by sorting the NYSE/AMEX/NASDAQ stocks based on
the realized and conditional beta. Realized beta is computed using daily returns over the previous month with the lagged market return. Portfolios are
generated based on the NYSE breakpoints and skipping the month following portfolio formation. Portfolio 1 (10) is the portfolio of stocks with the
lowest (highest) realized or conditional betas. The row “High-Low” refers to the difference in monthly returns between portfolios 10 and 1. The row
“Alpha” reports Jensen’s alpha with respect to the Fama-French (1993) model. Newey-West (1987) adjusted t-statistics are reported in parentheses.

β trealized
−2
β tAR
−1|t − 2 β tMA
−1|t − 2 β tGARCH
−1|t − 2

Average Average Average Average Average Average Average Average

Decile
Return Beta Return Beta Return Beta Return Beta
1 Low β 1.31 -1.56 1.17 0.21 1.15 0.22 1.14 0.19
2 1.31 -0.17 1.30 0.52 1.32 0.53 1.24 0.50
3 1.36 0.18 1.40 0.65 1.38 0.66 1.33 0.64
4 1.36 0.45 1.39 0.76 1.41 0.77 1.43 0.75
5 1.38 0.70 1.44 0.86 1.43 0.86 1.36 0.85
6 1.40 0.96 1.45 0.95 1.48 0.95 1.43 0.94
7 1.38 1.24 1.58 1.04 1.53 1.04 1.49 1.03
8 1.35 1.59 1.57 1.14 1.59 1.14 1.57 1.14
9 1.31 2.09 1.65 1.29 1.67 1.28 1.68 1.30
10 High β 1.23 3.82 1.87 1.73 1.87 1.69 2.06 1.80
-0.08 0.70 0.72 0.92
High–Low
(-0.51) (2.24) (2.29) (2.76)
-0.09 0.48 0.49 0.63
Alpha
(-0.82) (2.32) (2.38) (3.07)
 45

Table XIV. Equal-Weighted Beta Portfolios After Controlling for Size and Book-to-Market Simultaneously
This table presents average returns and FF-3 alphas of quintile portfolios of realized and conditional betas after controlling for size and book-to-market.
At the beginning of month t, the NYSE/AMEX/NASDAQ stocks are first sorted into 5 size (market equity) portfolios. Then within each size
portfolio, stocks are sorted into 5 BM (book-to-market equity ratio) portfolios. Finally, within each portfolio formed from the intersections of 5 size
and 5 BM portfolios, stocks are sorted into 5 beta portfolios, based on their realized and conditional betas in month t-1. Newey-West (1987) adjusted t-
statistics are provided in parentheses.

β trealized
−1
β tAR
|t −1 β tMA
|t −1 β tGARCH
|t −1

Average FF-3 Average FF-3 Average FF-3 Average FF-3

Decile
Return Alpha Return Alpha Return Alpha Return Alpha
Low β 1.2732 0.5247 0.8683 0.2522 0.8662 0.2508 0.8696 0.2698
(4.54) (6.56) (4.15) (3.42) (4.13) (3.45) (4.20) (3.48)
2 1.3314 0.5995 1.1267 0.3929 1.1177 0.3784 1.1098 0.3747
(5.17) (8.63) (4.49) (5.28) (4.46) (5.02) (4.51) (5.02)
3 1.3972 0.6191 1.3158 0.4946 1.3241 0.5098 1.3083 0.4908
(5.10) (9.25) (4.60) (6.84) (4.61) (6.97) (4.50) (6.71)
4 1.4673 0.6369 1.5273 0.6716 1.5293 0.6743 1.5254 0.6609
(4.75) (9.39) (4.56) (9.54) (4.59) (9.53) (4.66) (8.95)
High β 1.3166 0.4812 1.9599 1.0566 1.9629 1.0560 1.9979 1.0838
(3.63) (5.14) (4.61) (7.11) (4.60) (7.07) (4.55) (7.11)
High - Low 0.0434 -0.0435 1.0915 0.8044 1.0967 0.8052 1.1282 0.8141
(0.32) (-0.43) (3.95) (4.42) (3.95) (4.43) (3.83) (4.30)
 46

Table XV. Firm-Level Cross-Sectional Regressions within

the Conditional CAPM Framework

This table provides the time-series averages of the slope coefficients and the Newey-West (1987)
adjusted t-statistics (in parentheses) from the monthly cross-sectional Fama-MacBeth regressions of
raw return on stock i on its unconditional beta, estimated as its average conditional beta obtained
from AR(1), MA(1), or GARCH-in-mean specifications, and beta premium sensitivity, estimated
from the regression of its conditional betas on the expected market risk premium, proxied by the
lagged return on CRSP value-weighted index. The sample is from July 1963 to December 2004.

Conditional Beta Model Unconditional Beta Beta Premium Sensitivity

AR(1) 0.6220 (2.89) -0.0317 (-0.62)

MA(1) 0.6189 (2.85) -0.0167 (-0.35)

GARCH-in-mean 0.5705 (2.67) 0.0065 (0.18)

 47

Figure 1. Expected Beta and Expected Return for 10 Beta Portfolios

2.5

2.0

1.5 E(R) = 1.0569 + 0.5336*β

Expected Return

R2 = 0.9794

1.0

0.5

0.0
0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8
Expected Beta

Figure 2. Expected Beta vs Expected Return for 20 Beta Portfolios

2.5

2.0

E(R) = 1.0601 + 0.5290β

Expected Return

1.5 R2 = 0.9597

1.0

0.5

0.0
-0.2 0.3 0.8 1.3 1.8
Expected Beta
 48

Figure 3. Expected Beta vs Expected Return for 50 Beta Portfolios

3.0

2.5

Expected Return
2.0

E(R) = 1.0599 + 0.5292β

1.5 R2 = 0.8847

1.0

0.5

0.0
-0.4 0.1 0.6 1.1 1.6 2.1
Expected Beta

Figure 4. Expected Beta vs Expected Return for 100 Beta Portfolios

3.0

2.5

2.0
Expected Return

E(R) = 1.0641 + 0.5233β

R2 = 0.8150
1.5

1.0

0.5

0.0
-0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0
Expected Beta