Estimating Betas from High-Frequency Data1

Qianqiu Liu

Department of Financial Economics and Institutions, College of Business Administration , University of Hawaii, 2404 Maile Way, Honolulu, HI 96822. E-mail:Qliu@cba.hawaii.edu. I thank Ravi Jagannathan for providing me with the S&P 500 futures intraday data and his helpful suggestions and guidance. I am also grateful to Kent Daniel, Vadim Linetsky, Robert McDonald, Adriano Rampini, Ronnie Sadka, Anna Scherbina, and Hengfu Zou, as well as conference participants at the 2002 Midwest Economics Association Annual Meeting, for their helpful comments. Special thanks are due to Torben Andersen for his consistent guidance and support. All mistakes are mine.

Estimating Betas from High-Frequency Data

ABSTRACT

This paper explores how to estimate betas from high-frequency data. A market model is developed and a consistent beta estimator using high-frequency returns is derived. Highfrequency intraday price quotes on individual stocks in the Dow Jones Industrial Average and trade prices of S&P 500 futures contracts from Chicago Mercantile Exchange over a six-year period are used in the empirical analysis. We find the sum of lead 1, 2 period beta, the contemporaneous beta, and lag 1, 2 period beta can be used as the consistent estimator of the security beta. The time-varying monthly and quarterly betas are computed using this method. In-sample and out-of-sample tests indicate that time-varying betas can substantially decrease the beta measurement error, but this has limited practical value for hedging, whether for individual stocks or the equally-weighted portfolio constructed with the thirty stocks in DJIA.

1. Introduction The fundamental concept of systematic risk or beta for a security is central to contemporary theory in nance. Thus, not surprisingly, there is much empirical work in nance focusing on the associated problem of estimating this systematic risk or beta. Typically, common stock beta estimates are obtained by regressing the continuously compounded rate of return of a stock on that of a market index such as the S&P 500. One of the earliest sources of data available for estimating betas was the CRSP tape of monthly stock prices that is compiled at the center for Research in Security Prices in the University of Chicago. For this reason, beta estimates were initially obtained from regressions run on returns computed over monthly time intervals. Later, daily returns were available and betas were computed for returns measured using daily intervals. However, many securities listed on organized exchanges are traded only infrequently, with few securities so actively traded that prices are recorded almost continuously. Thus the use of daily data introduces serious biases into the beta estimates, especially for the more thinly traded stocks. Taking microstructure eects into account, Cohen, Hawawini, Maier, Schwartz and Whitcomb (1983), Scholes and Williams (1977), and Dimson (1979) propose dierent consistent beta estimates from the daily returns. In recent years, the ever lower costs of data recording and storage make time-stamped observations on all quotes and transactions available for many important nancial markets. The advent of high-frequency data poses interesting challenges and opportunities to empirical work. In this paper, we reconsider the beta estimation problem from high-frequency data. In theory, following the work of Merton (1980) and Nelson (1992), we know that for a continuous time diusion process, the diusion coecient can be estimated arbitrarily well from an arbitrarily short span of data with suciently nely sampled observations. Here we use a six-year sample of continuously recorded prices quotes for all the thirty stocks in the Dow Jones Industrial Average (DJIA) as an approxmation of the continuous time process. Of course, there are market microstructure frictions with the intraday data, including price discreteness, infrequent trading, and bid-ask bounce. In order to mitigate them, we use a ve-minute return horizon as the eective continuous time record which is the same as in Andersen, Bollerslev, Diebold and Ebens (2001, henceforth ABDE). Since the daily return time series can be expressed as summation of all the intraday ve-minute returns, we can construct the estimates of variances and covariances by the summation of the cross-products of the intraday ve-minute returns. This allows us to characterize the security beta with a simple market model. With the estimates of variances and covariances and some simplifying assumptions, a formula for beta using intraday high-frequency returns is derived and it is found that many lead and lag security betas should be included to get the consistent beta estimates. Then we empirically test the estimator for the thirty DJIA stocks and construct a computationally convenient, consistent estimator for beta. The consistent estimator for beta is calculated as a combination of ordinary least squares estimators. Specically, it is the sum of 1

betas estimated by regressing the returns on the security against returns on the market from the previous two periods, current and subsequent two periods. With this method, we estimate the quarterly betas and monthly betas for the thirty stocks. In the literature about cross-section regressions such as Black, Jensen and Scholes (1972), Fama and French (1992), a grouping procedure is proposed to minimize the measurement error bias since estimates of market betas are more precise for portfolios. In essence the procedure amounts to systematically sorting the rms into groups and then calculating the beta for each portfolio using the time series of portfolio returns. A typical way is to estimate the pre-ranking beta of each rm by the slope coecient in the regression of 24 to 60 months of past-return data on a constant and a market index of the corresponding months. Firms are then sorted based on their pre-ranking betas and returns on each of these portfolios for the next 12 calendar months is computed by equally weighting the returns on stocks in the portfolio. This procedure is repeated for each calendar year. These portfolio returns are then used to estimate the group betas. Compared with this procedure, our estimator using high-frequency data has two advantages. First, by sampling the return process more frequently, we get the beta estimates of the individual rm directly instead of using the corresponding group beta as a proxy. Second, although assigning full-period portfolio betas to stocks does not mean that a stocks beta is constant since a stock can move across portfolios with the estimates of its beta for the preceding ve years, it implies that its beta does not change in at least a calendar year and may only attain a few xed values which depend on the number of portfolios in the full sample. Instead, our time-varying betas should provide a more precise estimate of the relative risk of a rms cash ow during the business cycle. According to Jagannathan and Wang (1996), we conjecture that our estimates can improve the explanatory power of the CAPM for the cross-sectional variation in average returns. These series of time-varying betas allow for investigation of their autocorrelation structure and can also be used to forecast the betas in the future month or over longer horizons. We rst use a simple AR(1) model to estimate the quarterly betas and measure the mean-squares error. In-sample test results indicate that betas vary over time in a substantial way for the individual stocks and time-varying beta estimates for almost all the stocks have smaller errors than those of their corresponding constant beta estimates. We also use realized monthly betas to develop an out-of-sample test. We followed the Box and Jenkins (1976) method, and used AIC (Akaikes Information Criterion) and SBC (Schwarzs Bayesian Criterion) to pick the best ARIMA model. Then we use the chosen model to forecast the monthly betas in the following 18 months. ARMA(1,1), AR(1), MA(1) and constant beta models are also chosen to forecast the future betas and compared with the chosen model. These out-of-sample tests show that the ARMA(1,1) model performs best for most stocks according to the square root forecast error and the constant beta model performs worst. On the average, the forecast error decrease from 0.3130 to 0.2273 if we use an ARMA(1,1) instead of the constant beta model.

The beta of an individual security measures its sensitivity to market movements. The portfolio beta is the weighted average of beta across all the assets included. Thus, accurate measuring betas is not only important in measuring the cost of capital of a security, it is also likely to have practical value in hedging. We use the time-varying monthly beta forecasts to construct the residuals series for the daily and monthly returns. For the monthly returns of all the individual stocks, we do not nd evidence that standard deviations of the noise terms are smaller than those of constant beta forecasts. For the daily returns of all the individual stocks, we nd that standard deviations of the idiosyncratic noises are smaller than those of constant beta forecasts, but the improvements are very small. Further analysis indicates that in most cases for the individual stocks, the variances of the noise terms dominate those of the return component that is explained by the deviation of the beta from its mean although the variance of the beta series is not small. To potentially mitigate this problem, we use the thirty stocks to form an equal-weighted portfolio. For the monthly returns of the portfolio, we still did not nd improvement of standard deviation of the noise series. Although the variance of the portfolios noise term is much smaller than that of an individual stock, the variance of the portfolios time-varying betas is also very small compared to that of an individual stock. But for the portfolio formed with the high beta correlated stocks, the time-varying betas did perform much better. The rest of the paper is organized as follows. In section 2, the proposed method for estimating beta is derived and described. In section 3, under some additional assumptions, we nd that the security beta is a weighted average of its intraday beta and overnight beta, where the weight is determined by the variance ratio of the intraday market index return to the overnight market index return. Section 4 discusses the actual data and empirical results. In Section 5 the estimates of quarterly and monthly beta estimates are given, and then an AR(1) model to describe the quarterly betas is presented. The results are contrasted with the constant beta estimator. We also develop an out-of-sample test and nd that the beta measurement error from an ARMA(1,1) model is much smaller than that of the constant beta model. But this improvement in beta estimation may only have limited practical value in hedging, whether for individual stocks or the equally-weighted portfolio constructed with the thirty Dow Jones Stocks. For a portfolio formed with stocks that have a high beta correlation, the improvement is much bigger. All these facts are documented in section 6. Section 7 discusses some issues which arise from this study and presents some concluding remarks. 2. The Model Dening returns as the log of price relatives adjusted for dividends and splits, we assume: (A.1): The return for security j in trading day t is generated by the market

model, rj,t = j + j rM,t + j,t (1)

We normalize the unit time interval to represent a trading day. The return in a trading day is the sum of all the returns of the high-frequency returns in the day(we implicitly assume here that the overnight returns are zero. For the general case, we defer to section 6): rj,t = rj,t,1 + rj,t,2 + ... + rj,t,N rM,t = rM,t,1 + rM,t,2 + ... + rM,t,N (2) (3)

Here N is the sampling frequency in a trading day, and M represents the market index. Thus, rj,t,k is the return of security j in interval k in a trading day t, and rM,t,k is the return of the market index M in interval k in day t. We further assume: (A.2): E (j,t ) = 0 for all j and t; (A.3): rM,t and j,t are uncorrelated for all j, t; (A.4): rM,t,m and rM,t,n are uncorrelated for all t, m 6= n and 1 m, n N . Proposition 1: The contemporaneous covariance between the returns of any security j and a market index M in a high-frequency interval, plus the sum of the serial cross-covariance of their returns for all leads and lags up to N 1 periods, equals the contemporaneous covariance between the daily returns of j and M . That is, cov (rj,t , rM,t ) =
N X

cov (rj,t,n , rM,t,n ) +

n=1

n=2

N X

cov (rj,t,n , rM,t,n1 ) cov (rj,t,n1 , rM,t,n )

+... + cov (rj,t,N , rM,t,1 ) + +

N X

n=2

N X

n=3

cov (rj,t,n2 , rM,t,n ) + ... + cov (rj,t,1 , rM,t,N )

N X

N 1 X

k=0 n=k+1

cov (rj,t,n , rM,t,nk ) +

N 1 X

k=1 n=k+1

N X

cov (rj,t,nk , rM,t,n )

We can get the result simply by the denition of covariance and expanding the terms. Proposition 2: The sum of variance of the returns of the market index M in a high-frequency interval equals the variance of the daily market index 4

returns. That is, var(rM,t ) =

N X

var(rM,t,n )

n=1

This result can be derived by the denition of the variance and (A.4). We can now derive the relationship between a securitys systematic risk calculated from high-frequency returns and the security beta. Dene the following variables:
N X N X

j,0 j,+k j,k j

cov (rj,t,n , rM,t,n )/

var(rM,t,n ),
N X N X

n=1

n=1

n=k+1

N X N X

cov (rj,t,n , rM,t,nk )/ cov (rj,t,nk , rM,t,n )/

n=k+1

var(rM,t,nk ), var(rM,t,n ),

n=k+1

n=k+1

= cov (rj,t , rM,t )/var(rM,t ),

where we call j,0 the high-frequency contemporaneous security beta, j,+k and j,k the high-frequency lead and lag k period security beta, and j the security beta.1 Proposition 3: The beta of security j is a function of the high-frequency contemporaneous security beta, and the lead and lag security beta up to N 1 periods; in particular N N P P var ( r ) var ( r ) M,t,nk M,t,n N 1 N 1 X X n=k+1 n=k+1 j = j,0 + + j,k N N j,+k P P k=1 k =1 var(rM,t,n ) var(rM,t,n )
n=1 n=1

It is easy to obtain the result from Proposition 1 and 2.

Proposition 4: The consistent estimator of the security beta can be found by the formula
1 Note that although the de nition of beta includes time index t, it is taken as a constant or a parameter to be estimated, which is the same as the conventional beta estimate as in Scholes and Williams (1977), and CHMSW (1983). Even when we talk about time-varying betas later, they are still seen as xed over some horizon. In other words, we dont treat beta changing everyday and estimate its expected value. We use unconditional covariance and variance estimates to estimate beta, which make Jensens inequality type adjustment unnecessary.

c = bj,0 + j

N 1 X

(4) where bj,0 , bj,+k and bj,k are OLS regression estimators of j,0 , j,+k and j,k , respectively. The proof of Proposition 4 follows immediately from Proposition 3.

var(rM,t,nk ) var(rM,t,n ) N 1 X n=k+1 n=k+1 b + j,+k bj,k N N P P k=1 k =1 var(rM,t,n ) var(rM,t,n )

n=1 n=1

N P

N P

It is clear from Proposition 4 that bj,0 , the OLS regression estimate of systematic risk using only contemporaneous returns, will generally be a biased estimator of the security beta j .

3. Overnight Beta Estimates The overnight period is from close of the previous trading day to open of the subsequent trading day, e.g., overnight -Monday is the period from close-Friday to open-Monday. Overnight returns are computed as the natural logarithm of the stock price relative, adjusted for dividends and splits. These overnight returns can also be used to estimate security beta. The return from close of the previous trading day to close of the subsequent trading day ( which is the daily return used in the literature most of the time ) can be expressed as: rj,t = rj,t,o+ rj,t,d rM,t = rM,t,o+ rM,t,d (5) (6)

where rj,t,o and rM,t,o are the overnight return of security j and market index M at day t, respectively; and the intraday returns are dened as in section 2: rj,t,d = rj,t,1 + rj,t,2 + ... + rj,t,N rM,t,d = rM,t,1 + rM,t,2 + ... + rM,t,N (7) (8)

where N is the sampling frequency in a trading day. We further assume: (A.5): rM,t,o and rM,t,d are uncorrelated for all t; (A.6): rj,t,o and rM,t,d are uncorrelated for all j, t;

(A.7): rM,t,o and rj,t,d are uncorrelated for all j, t. Proposition 5: The contemporaneous covariance between the overnight returns of any security j and a market index M , plus the sum of the contemporaneous covariance between the intraday returns of j and M , equals the contemporaneous covariance between the daily returns of j and M . That is, cov (rj,t , rM,t ) = cov (rj,t,o , rM,t,o ) + cov (rj,t,d , rM,t,d ) Proof: From equation (4) and (5), we know cov (rj,t , rM,t ) = cov (rj,t,o , rM,t,o ) + cov (rj,t,o , rM,t,d ) + cov (rj,t,d , rM,t,o ) + cov (rj,t,d , rM,t,d ) = cov (rj,t,o , rM,t,o ) + cov (rj,t,d , rM,t,d ) The last step follows (A.6) and (A.7). Proposition 6: The sum of variance of the returns of a market index M in a high-frequency interval and variance of overnight returns equals the variance of the daily market index returns. That is, var(rM,t ) = var(rM,t,o ) + var(rM,t,d ) The proof of Proposition 6 follows directly from Proposition 2 and (A.5). We can now derive the relationship between a securitys systematic risk calculated from overnight returns and intraday high-frequency returns. Dene the following variables: d j o j M = cov (rj,t,d , rM,t,d )/var(rM,t,d ), = cov (rj,t,o , rM,t,o )/var(rM,t,o ), = var(rM,t,d )/var(rM,t,o ),

o where we call d j the intraday beta, j the overnight beta, and M is the ratio of the variance of the intraday market index return (from open to close) to the variance of the overnight market index return. The relationship between these variables is expressed in Proposition 7.

Proposition 7: The beta of security j is a weighted average of its intraday beta and overnight beta; in particular j = 1 M o + d M + 1 j M + 1 j (9)

Proof: j =

cov (rj,t , rM,t ) var(rM,t ) 7

= =

cov (rj,t,o , rM,t,o ) + cov (rj,t,d , rM,t,d ) var(rM,t,o ) + var(rM,t,d )

1 cov (rj,t,o , rM,t,o ) M cov (rj,t,d , rM,t,d ) + M + 1 var(rM,t,o ) M + 1 var(rM,t,d ) = M 1 o + d M + 1 j M + 1 j

Proposition 8: The consistent estimator of the security beta can be found by the formula c= j
2 X 1 M + bj,k ) bo ( M + 1 j M + 1 k=2

(10)

o where bo j is the OLS regression estimator of the overnight beta j ; bj,0 , bj,+k and bj,k are OLS regression estimators of j,0 , j,+k and j,k , respectively. M is the ratio of the variance of the intraday market index return to the variance of the overnight market index return.

The proof of Proposition 8 follows immediately from Proposition 4 and 7. 4. Empirical Results 4.1. Data Our empirical analysis is based on data from the Trade and Quotation (TAQ) database. The TAQ data les contain continuously recorded information on the trades and quotations for the securities listed on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), and the National Association of Security Dealers Automated Quotation system (NASDAQ). The database is published monthly, and has been available since January 1993. Our sample extends from January 2, 1993 until December 31, 1998, for a total of 1516 trading days, and consists of all the quotes for the thirty DJIA rms, as of the reconguration of the index on November 1, 2000.2 A list of the relevant ticker symbols is contained in the tables below. The DJIA stocks are among the most actively traded U.S. equities and represent about one-fth of the value of all US stocks. According to ABDE (2001), the median length time between trades for all of the stocks across the full sample is only 23.1 seconds, and the median length of the times range from a low of 7 seconds for Merck & Co. Inc.(MRK) to a high of 54 seconds for United
2 We also experimented with the use of transcation prices instead of price quotes for the thirty DIJA stocks, which produced very similar empirical results.

Technologies Corp.(UTX). As such, it is not practically feasible to push the continuous record asymptotics and the length of the observation interval beyond this level. Moreover, because of the organizational structure of the market, the available quotes and transaction prices are subject to discrete clustering, infrequent trading, and bid-ask spread eects. Such market microstructure features are generally not important when analyzing longer horizon interdaily returns but can seriously distort the distributional properties of high-frequency intraday returns. Following the analysis in ABDE (2001), we rely on articially constructed ve-minute returns. The daily transaction record extends from 9:30 EST until 16:00 EST, but to guarantee there are enough records and to exclude many outliers in the opening of the stock markets, our sample only include the records from 10:00 EST to 16:00 EST each trading day. Thus there are a total of 72 veminute returns for each day. The ve-minute horizon strikes a balance between being short enough so that the accuracy of the continuous record asymptotics works well, and long enough so that the confounding inuences from market microstructure frictions are not overwhelming. We use intraday observations on the S&P 500 futures contracts from Chicago Mercantile Exchange (CME) as the market index proxy. These contracts expire on the third Friday of four monthsMarch, June, September, and December. The outstanding contract closest to expiration is chosen. However, to ensure that the most actively traded contract is used, the next contract is chosen on the tenth day of the expiration month for the S&P 500 futures. The period covered by the data is the same as those of the thirty DJIA stocks, from 9:00 CST to 15:00 CST each trading day from January 2, 1993 until December 31, 1998.3 4.2 Empirical Results The ve-minute return series for the thirty stocks in DJIA are constructed from the dierence between the linearly interpolated logarithmic midpoint of the continuously-recorded bid and ask quotes that are recorded at or immediately before the corresponding ve-minute marks. Similarly, the ve-minute return series of the S&P 500 futures are constructed, except that they are the logarithmic dierence between the trade prices. In order to purge the highfrequency returns of the negative serial correlation induced by nonsynchronous trading and the bid-ask spread, we rst estimate an MA(1) model for each of the ve-minute return series. Consistent with the spurious dependence that would be induced by non-synchronous trading and the bid-ask spread, almost all estimated moving-average coecients are negative, which can be seen in Table 1. We denote the corresponding thirty demeaned MA(1)-ltered return series of 721514=109008 ve-minute returns by rj,t,n where t = 1, 2, ...1514, n = 1, 2, ..., 72 and j denotes an individual stock in the thirty stocks in DJIA. The corresponding ltered series can also be constructed for S&P500 futures,
3 There are two days missing in the CME data, compared with DJIA TAQ database. One is June 27,1995; another is December 18,1998. Therefore, a total of 1514 trading days are used in our empirical analysis.

and we use rM,t,n to denote it.4 Examining Table 1, it is clear that the means of all the ve minute series are close to zero. The rst and second autocorrelation of all the demeaned MA(1) ltered return series are not signicant from zero. The higher order autocorrelations are also calculated and are found to have the same characteristics. In Table 2, we give the summary statistics about the overnight return of all the thirty stocks and the market index.5 From this table, we can see that the variance ratio of the market index is close to 3. The rst autocorrelation of the overnight return series of the market index is only -0.0142. The correlation between the overnight returns and intraday returns of the market index is only -0.0167, which is not included in the table. This gives support to (A.7). In Table 3, we give bj,0 , bj,+p and bj,p (1 p 5) which are OLS regression estimators of j,0 , j,+p and j,p (1 p 5) for all the thirty stocks. To allow for heteroscedasticity present in the residuals, White t-statistics are reported. To conserve the space, we only report the estimates which are signicant at the 5 percent level. It is evident from the table that all the contemporaneous security and lead 1 beta estimators are highly signicant. The minimum t-statistics of bj,+1 is 16.1446 and the maximum is 45.6727. The minimum and maximum t-statistics of bj,+0 are 32.5552 and 66.0743, respectively. In the mean time, there are 23 signicant lead 2, 16 signicant lag 2, 6 signicant lag 1 and 5 signicant lead 3 security beta estimators. On the other hand, there are only 2 lag 3, 3 lag 4, 5, and 1 lead 4, 5 security beta estimators of all the thirty stocks which are signicant. We also compute the lead and lag beta estimators from 6 to 10 periods. For each higher order lead and lag beta ( 5) estimators, there are less than 2 signicant among the thirty stocks. If we use the 0.1 percent level as the test size for these large samples of ve-minute returns, we nd that all the contemporaneous and lead 1 betas are signicant. On the contrary, none of those higher order lead and lag beta ( 3) estimators are siginicant at the new signicance level.6
4 As is well known, non-synchronous trading and bid-ask spread will typically induce negative autocorrelation for individual security returns. Such aspects can be safely ignored when longer horizons are involved, but it will bring potentially serious biases to the high-frequency data we considered. Here we assume the ltered returns are virtual returns which represent changes in the underlying value of the security in the absence of any trading frictions or other institutional rigidities. They re ect both company-specic information and economy-wide effects, and in a frictionless market, these returns would be identical to the observed returns of the security. 5 When we computed the overnight returns, we have already adjusted for dividends and splits. During the sample period, there are some mergers and acquisition deals for some of the stocks. In any case, we use PERMNO as the unique standard to decide the return series for a security. PERMNO neither changes during an issues trading history, nor is it reassigned after an issue ceases trading. We can track a security through its entire trading history with one PERMNO, regardless of name changes or capital structure changes. In the strict sense, beta for the same security in dierent period may stands for di erent company. 6 Chan (1992) suggests that lower signi cance may be required for large samples. If we use the 0.1 percent level of signicance as the rejection criterion which is the same as what he adopted in his paper, we nd that all the contemporaneous and lead 1 betas are still signi cant. At the same time, there are 16 signi cant lead 2 betas, 3 signicant lag 1 and lag

10

The appropriate selection of the number of the lead and lag betas to be included in (4) represents a direct conict between model and statistical accuracy. When we include the greater number of lead and lag terms, the beta estimator is more accurate in theory, but at the same time, we also bring more potential noise from the estimation process. In other words, the estimator is less biased when more lead and lag betas are included, but the statistical eciency declines. Simple T-tests of cross-sectional betas indicate that among all the betas, only the contemparaneous beta, lead 1, 2 beta, and lag 2 beta are signicantly dierent from zero at the 5 percent level. According to these empirical results, we will only include lead 2, 1 period beta, the contemporaneous beta, and lag 1, 2 period beta in the estimator of the security beta.7 We also observe from Proposition 4 that, for a xed k , the coecient with the lead and lag betas with order less than k will be close to 1 as N increases.8 Based on this evidence, we can use bj,0 + bj,+1 + bj,+2 + bj,1 + bj,2 as a computationally convenient consistent estimator of the beta of security j .9 Similarly, a consistent beta estimator from intraday returns and overnight returns as in Proposition 8 can be obtained. For comparison, we also utilize the daily and monthly returns from CRSP to get the beta estimate. The daily Scholes-Williams beta estimator is computed as well.10 All these results are in Table 4. From this table, we can see that beta estimates from dierent source of data for the same security are reasonably close. This is not surprising, given that the DJIA stocks are among the most actively traded U.S. equities and nontrading is not serious for the daily return series. When we use standard deviation to measure the dispersion of the betas of the thirty DJIA stocks from dierent methods, we nd our beta estimator using intraday ve-minutes returns has the smallest dispersion: 0.1373, which is much
2 betas, while none of the higher order lead and lag betas are sigini cant at the 0.1 percent level. 7 We also experimented with the use of the sum of lead 3 to lag 2 period betas, and the sum of lead 5 to lag 5 betas as the estimator of the security beta, which give very similar estimates to what we get from the sum of lead 2 to lag 2 betas. But they lead to a little bigger beta dispersion of all the thirty stocks. 8 To be more precise, we need the following assumption : k, 1 k N , as the sampling frequency N goes to innity ( or the maximal length of the sampling interval goes to zero ),
var (rM,t,k ) N P var (rM,t,n )

0.

and b+ j represent the OLS estimators of lag 1, contemporaneous, lead 1 beta respectively and d M is the estimator of the rst-autocorrelation of the market returns. It takes nonsynchronous trading into account and is applied to get consistent estimate of betas from daily returns of securities.

9 We also experimented with the use of ten-minute returns and thirty-minute returns and found very close estimates of the security beta. These returns can be constructed from the sum of the corresponding ve-minute returns. We only need to adjust the number of the lead and leg betas to be included in the beta estimate. For example, we can use the sum of the contemporaneous beta, lead 1 beta and lag 1 beta of thirty-minute returns to get the security beta estimate. 1 0 The Scholes-Williams estimator is computed as c = (b +bj +b+ )/(1+2 d j M ) where bj , bj , j j

n=1

11

smaller than those from other methods. We also try to include more lead and leg betas to estimate the security beta. The dispersion of betas measured from lead 5 to lag 5 is 0.1695. It is 0.1886 if we use lead 8 to lag 8 betas. It is apparent that when we include more leads and lags to measure the security beta, the dispersion is bigger (beta using daily returns or monthly returns can be also included in this case if we take the daily or monthly returns as the sum of many ve-minute returns and therefore traditional beta estimate includes more leads and lags in the beta measurement). If adding many higher order lead and lag betas only brings noise to the beta measurement, to improve the beta measure precision, we should not include too many lead and lag betas. This also gives some empirical support for our beta estimator from high-frequency data. Two other facts about the betas are important. First, although we only use 30 thirty stocks in our study, the spread of betas can be compared with those in Black, Jensen and Scholes (1972), Fama and French (1992) which use all the stocks in NYSE and NYSE/AMEX/NASDAQ respectively. In BJS, the estimated betas range from 1.5614 for portfolio 1 to 0.4992 for portfolio 10. The portfolios formed on the basis of the ranked betas have betas ranging from 0.81 to 1.73 in FF. Both of them use monthly returns to compute the betas. The betas estimated from monthly returns of the thirty DJIA stocks range from 0.3334 to 1.7401 in Table 3. Second, the mean of all the thirty stocks betas from dierent estimation methods is around 1. We take these to be evidence that the estimated betas of the thirty stocks are reasonably representative. 5. Time-Varying Beta Estimates Several empirical studies of beta-pricing models reported in the literature nd that betas exhibit statistically signicant variability over time.11 Moreover, in empirical studies that examine the reaction of stock prices to certain events, it has become common practice to allow for time variations in betas. The empirical procedure that we adopted in section 3 can also be used to get timevarying beta estimates, such as monthly beta or quarterly beta estimates. These estimates are only feasible within a high-frequency context because the number of intraday observations is typically very large.12 These time-varying betas can be used to examine their autocorrelation structure and forecast the betas in the future month or longer horizon. The potential applications are broad. In the existing literature about cross-sectional regressions such as Black, Jensen and Scholes (1972), Fama and French (1992), a grouping procedure is posed to minimize the beta measurement error bias. This procedure systematically sorts the rms into groups and then calculates the beta for each portfolio using the time series of portfolio returns. Compared with this procedure, our
1 1 See Bollerslev, Engle, and Wooldridge (1988), Harvey (1989), and Ferson and Harvey (1991). 1 2 From now on, we will not use overnight returns to estimate betas, as in Proposition 8. The reason is that we only have a very small sample size of overnight returns when we try to estimate betas every month or quarter, thus inevitably we will have big measurement errors with overnight beta estimates.

12

beta estimator not only estimates the systematic risk of an individual rm directly instead of using the corresponding group beta as a proxy, but also allows for full exibility. In contrast, the number of values that a security beta can attain in the old procedure depends on the number of the portfolios formed. We rst compute the quarterly betas for the thirty DJIA stocks. The betas of all the stocks are estimated with the sum from lead 3 to lag 2 beta in each quarter as the benchmark for comparison. The sample covers the period from January 2,1993 through December 31,1998, thus there are altogether 24 quarterly betas for an individual stock. In Table 4, we give some descriptive statistics of the time-varying betas for each stock. The beta of an individual stock can change a lot. For most of the 30 stocks, the maximum quarterly beta is more than twice as large as the minimum. For stock XON, the maximum quarterly beta is four times bigger than its minimum one. In addition, there is signicant rst order autocorrelation of the quarterly beta series for every stock. Beta series of stock HD has the maximum rst order autocorrelation 0.7723, while even the smallest rst order autocorrelation (stock JPM) is as big as 0.2259. To capture the apparent time variation and the signicant rst order autocorrelation of the beta series, a simple AR(1) model is used to estimate the time series of quarterly betas. In Table 4, the mean-square errors (MSE) are given for AR(1) tted quarterly betas compared to using a constant beta as the estimator. The mean-square error coecient is computed as follows: M SE ( j ) =
23 X

h=1

where h j is the beta of stock j at quarter h as measured by high-frequency data c h using the derived formula in section 3 and h j is the estimator of j . We take the rst quarterly beta as given and it is used to estimate the beta in the following quarters. The denominator is two less than the number of the observations used in the estimation to adjust for the parameters used in the model. All the stocks, except JPM, have MSE of AR(1) model less than their variance. The variance is MSE of the best estimator of the security beta using a constant. In theory, adding one lag term in the regression is never worse than using only the constant term. Here the fact that the MSE of AR(1) model of stock JPM is larger than its variance is due to the adjustment for degrees of freedom in the estimation. To check the robustness of these results, we develop an out-of-sample forecast analysis with a sample of continuously recorded intraday data for all the thirty stocks in DJIA, from January 4, 1999 to June 30, 2000. Following the Box and Jenkins (1976) method, we pick the best ARIMA model for the 72 monthly beta series (from January 1993 to December 1998) of an individual stock based

c h 2 ( h j j ) /21

(11)

13

on estimates from high-frequency returns. 13 14 We then use the chosen model to make a one-step ahead beta forecast for the next month in the 18 following months, adding one monthly beta computed from the same approach as in section 3 to the old sample every time. To make comparisons, we also use simple models such as ARMA(1,1), AR(1), MA(1) and constant beta models to make forecasts. In Table 6, the square root errors(SRE) are given for forecasted monthly betas compared to the estimate monthly betas from high-frequency returns in the same period. The square root error is computed as follows: v u 18 uX f h 2 SRE ( j ) = t ( h j j ) /18
h=1

(12)

f h h where h j is the beta of stock j at month h and j is the forecast of j . From Table 5, we can see on the average, ARMA(1,1) model performs best and the average beta forecast error for the thirty stocks is 0.2273 although ARMA(1,1) is not always the best in-sample tted ARIMA model. It is chosen only for ten stocks; for other stocks, higher order ARIMA, AR(1), MA(1), or constant beta models were picked based on in-sample evidence. The average SRE with ARMA(1,1) is even less than that of the in-sample selected models.15 The constant beta model performs the worst, with the average SRE 0.3130. AR(1) has an average SRE of 0.2525, which is worse than the in-sample selected models but better than the average SRE of 0.2756 with MA(1). 6. Application for Hedging Does this improvement in beta measurement have large practical value in hedging? To answer this question, we consider the noise of the market model: j,t = rj,t j rM,t (13)

We consider the monthly noise series obtained from time-varying monthly beta estimates based on high-frequency returns and the constant beta during the 90 months of the full sample from January 1993 to June 2000 for all the individual stocks. The results in Table 6 indicate that there is no evidence that standard deviations of the noise series of the time-varying betas are smaller than those of constant beta estimate. Some of them from time-varying betas are even bigger than their constant beta counterpart. But there is no signicant dierence. We also use the excess returns to replace the raw returns, where
1 3 The criteria include the AIC (Akaikes Information Criterion), SBC (Schwarzs Bayesian Criterion), and the t-statistics for those coe cient estimates. Speci cally, we looked for a model that had the lowest AIC and SBC values, with all the regression coe cients being statistically signi cant. 1 4 We also explored GMM and got similar results. 1 5 This suggests an interpretation in terms of measurement error. Suppose a time series really follows an AR(1), but is observed with i.i.d. measurement error, then the obeserved series will follow an ARMA(1,1).

14

dierent proxies for the risk free asset such as the 3-month T-bill and the one year government bond are used. The conclusion is the same. To analyze the change of the noise series caused by the beta deviation of the time-varying betas from the constant beta, we compute Var( t ), Var(t ), Var( t rm,t ), Cov( t rm,t , t ), and Cov( t rm,t , rm,t ). t = t , where t is the time-varying beta estimate at month t from the highfrequency data, and is the constant beta estimate using the regression of the monthly returns of a stock in the full sample period on a constant and market index . rm,t = rm,t rf,t , where rm,t is the return of the market index at month t, and rf,t is the return of the risk free rate at month t. We use the 3 month T-bill as the proxy for the riskless asset in Table 7. From Table 7, we nd that for the individual stocks, the variances of the noises are much bigger (at least ten times for almost all the stocks) than those variances and covariances that are due to the deviation of the beta from its mean although the variance of the beta series is not small. Thus, the idiosyncratic risks dominate and there is no indication of an improvement even if we exploit a better measure of the systematic risks of the stocks. To further investigate this problem, we also consider the daily returns of all the thirty stocks from January 4,1999 to June 30, 2000. This time, we use the beta forecasts to construct the noise series. Beta forecasts from ARMA(1,1) model and constant beta model are chosen, where monthly beta forecasts are used to construct the noise series for all the daily returns in the same month. We show all the results in Table 8. All the standard deviations of the noise series of ARMA(1,1) forecasted betas are smaller than or equal to those of constant beta forecast. But the dierence of the two noise series is very small for all the stocks; the former at most represents a 4% improvement on the latter according to its standard deviation. To minimize the inuence of the idiosyncratic risk, a natural way is to construct a portfolio instead of using individual stocks since much of the idiosyncratic risk should cancel out in a portfolio. To this end, we form an equalweighted portfolio using all the thirty stocks in DJIA. We construct the monthly and daily returns for the portfolio and do the same analysis as before. There is still not much improvement. But the reason is dierent from the individual stocks. In this case, although the variance of the noise of the portfolio (Var(t )=0.0003) is much smaller than those of the individual stocks, betas vary very little (Var( t )=0.0323) compared to individual stocks at the same time. Therefore the variance of the noise is still much bigger than those variances and covariances that are due to the deviation of the beta from its mean. In fact, this portfolio can be seen as a proxy of the market index and it has a beta very close to one most of the time. Can we construct a portfolio whose beta variation can be compared with individual stocks? Based on the correlation of the monthly beta series of each stock in DJIA from January 1993 to December 1998, we pick up 8 stocks from them. They are AA, CAT, EK, GM, IBM, INTC, MCD and MMM. During this six-year period, the correlation between each pair of stocks is at least 0.2851. We form an equally-weighted portfolio with these stocks and use an ARMA(1,1) 15

model and a constant beta model to forecast its beta from January 1999 to June 2000. Then we use dierent forecasted beta series to construct the daily noise series as we did for individual stocks before. The noise series from ARMA(1,1) forecasted beta has a standard deviation of 0.0095 and it is about 8% improvement on the noise series from the constant beta model which has a standard deviation of 0.0103. Another good candidate is a portfolio with component stocks in the same industry. We conjecture that this kind of portfolio has betas varying over time in a substantial way. To this end, we form an equally-weighted portfolio with 5 airlines stocks from the largest airlines in US. They are AMR (American Airlines), DAL (Delta), LUV (Southwest), U (US Airways), and UAL (United).16 We choose an ARMA(1,1) model and a constant beta model to forecast its beta from January 1999 to June 2000. Then we use dierent forecasted beta series to construct the daily noise series as we did for individual stocks before. The noise series from ARMA(1,1) forecasted beta has a standard deviation of 0.0230 which is only 0.0001 smaller than that of the constant beta model. Compared with DJIA stocks, most of these ve stocks have larger beta measurement errors, whether from ARMA(1,1) model or constant beta model.17 At this stage, we are still uncertain whether the improvement in beta estimates has large practical value in hedging for the portfolios. Based on our current evidence, it has only limited value, but it is still possible for the improved time-varying beta estimates to have better hedging performance. We will construct more portfolios to explore this issue in the future. 7. Conclusion and Future Research Given the recent availability of high-frequency data, we reconsider the beta estimation problem and its application in this paper. In section 2, a consistent estimator of beta using ve-minute returns is derived under the market model and common assumptions. The consistent estimator of the security beta is computed as the weighted sum of lead, lag betas and the contemporaneous beta. In section 3, we use both the intraday returns and overnight returns to obtain a consistent estimator of the security beta. We nd that the security beta is a weighted average of its intraday beta and overnight beta, where the weight is determined by the variance ratio of the intraday market index return to the overnight market index return. In section 4, we use the high-frequency data from TAQ and CME to test the formula empirically. We nd that we can use the sum of the lead 2, 1 period beta, the contemporaneous beta, and lag 1,2 beta as the consistent estimator. The lead and lag betas can be easily obtained by OLS regressions. We also
1 6 Other major airlines include AWA (America West), CAL (Continental), NWAC (Northwest), and TWA (Trans World). We dont include them in the portfolio just because they dont have all the data from January 2,1993 to June 30, 2000. 1 7 One possible reason is that most of them are not so liquid as DJIA stocks, thus their beta estimates might incorporate big measurement errors.

16

give the beta estimates based on ve-minute returns and found them to be reasonably close to the beta estimates from daily or monthly returns, but has smaller cross-sectional beta dispersion. In section 5, we use the above formula to get beta estimates using only data in a month or a quarter. These time-varying betas can be used to estimate their autocorrelation structure and to forecast the betas in the future month or longer horizon. We use an AR(1) model to estimate the quarterly betas and measure the mean-squares error. It is not surprising that the AR(1)-estimated beta has a smaller MSE than that of the constant beta. We further develop out-of-sample tests based on monthly betas. Out-of-sample tests indicate that ARMA(1,1) performs the best according to the SRE of its forecasted beta series. In section 6, we implement the above empirical approach to explore the hedging performance of dierent beta estimates. We found that the improvement in beta estimation does not have much practical value in hedging, whether for individual stocks or the equally-weighted portfolio constructed with the thirty stocks in DJIA. But if we group stocks according to their beta correlation, there is a bigger improvement according to the standard deviation of the corresponding noise series. Beta estimation based on daily returns or monthly returns normally requires a sample with a long horizon. In contrast, our beta estimates using high-frequency data not only minimize the measurement error, but also allow more freedom for time-variations of the betas. Considering the important role of beta in asset pricing models, the empirical approach we develop in this paper can be applied in many ways. It can be used in event studies or in testing the conditional CAPM empirically. It is also interesting to explore the relation of the time-varying betas with some macroeconomic factors and other nancial variables, such as size, book-to-market ratio, etc. One issue of particular interest is whether the equity premium and beta move together over time. We also want to explore how to incorporate overnight returns into beta estimates in future research. Given the poor estimation precision of overnight beta estimator relative to intraday beta estimator, our initial guess is that we will have to down-weigh the overnight beta to allow for time-variation in the overnight beta.

17

References Andersen, T.G, 1991, Estimation of Systematic Risk in the Presence of Nontrading: Comments and Extensions, Unpublished Manuscript, Northwestern University. Andersen, T.G., T. Bollerslev, F.X. Diebold and H. Ebens, 2001, The Distribution of Stock Return Volatility, Journal of Financial Economics 61, 43-76. Andersen, T.G., T. Bollerslev, F.X. Diebold and P. Labys, 2001, The Distribution of Exchange Rate Volatility, Journal of the American Statistical Association 96, 42-55. Andersen, T.G., T. Bollerslev, F.X. Diebold and P. Labys, 2002, Modeling and Forecasting Realized Volatility, Econometrica, forthcoming. Black, F., M.C. Jensen and M. Scholes, 1972, The Capital Asset Pricing Model: Some Empirical Tests, in M. Jensen,ed.:Studies in the Theory of Capital Markets (Praeger). Box, G. E. P. and G.M. Jenkins, 1976, Time Series Analysis: Forecasting and Control, rev. ed, San Francisco: Holden Day. Bollerslev, T., R.F. Engle, and J.M. Wooldridge, 1988, A Capital Asset Pricing Model with Time Varying Covariances, Journal of Political Economy 96, 116-131. Chan, K., 1992, A Further Analysis of the Lead-Lag Relationship Bewteen the Cash Market and Stock Index Futures Market, Review of Financial Studies 5, 123-152. Cho, Y.H. and R. F. Engle, 1999, Time-Varying Betas and Asymmetric Eects of News: Empirical Analysis of Blue Chip Stocks, NBER Working Paper 7330. Cohen, K.J., G.A. Hawawini, S.F. Maier, R.A. Schwartz and D.K. Whitcomb, 1983a, Estimating and Adjusting for the Intervalling-Eect Bias in Beta, Management Science 29, 135-148. Cohen, K.J., G.A. Hawawini, S.F. Maier, R.A. Schwartz and D.K. Whitcomb, 1983b, Friction in the trading Process and the Estimation of Systematic Risk, Journal of Financial Economics 12, 263-278. Campbell, J., A. Lo and C. MacKinlay, 1997, Econometrics of Financial Markets, Princeton University Press. Daniel, K.D. and S. Titman, 1997, Evidence on the Characteristics of CrossSectional Variation in Common Stock Returns, Journal of Finance 52, 1-33. Dimson, E., 1979, Risk Measurement when Shares are Subject to infrequent Trading, Journal of Financial Economics 7, 197-226. Engle, R.F, 2000, The Econometrics of Ultra-High Frequency Data, Econometrica 68, 1-22. Fama, E.F. and K.R. French, 1992, The Cross-Section of Expected Stock Returns, Journal of Finance 47, 427-465. Fama, E.F. and J.D. MacBeth, 1973, Risk, Return and Equilibrium: Empirical Tests, Journal of Political Economy 71, 607-636. Fleming, J., C. Kirby and B. Ostdiek, 2003, The Economic Value of Volatility

18

Timing Using Realized Volatility, Journal of Financial Economics 67, 473509. Ferson, W.E. and C.R. Harvey, 1991, The Variation of Economic Risk Premiums, Journal of Political Economy 99,385-415. French, K.R., G.W. Schwert and R.F. Stambaugh, 1987, Expected Stock Returns and Volatility, Journal of Financial Economics 19, 3-29. French, K.R. and R. Roll, 1986, Stock Return Variances: The Arrival of Information and the Reaction of Traders, Journal of Financial Economics 17, 5-26. Foster, D. P. and D.B. Nelson, 1996, Continuous Record Asymptotics for Rolling Sample Variance Estimators, Econometrica 64, 139-174. Fowler, D.J. and C.H. Rorke, 1983, Risk Measurement when Shares are Subject to infrequent Trading, Journal of Financial Economics 12, 279-283. Harvey, C.R., 1989, Time-varying Conditional Covariances in Tests of Asset Pricing Models, Journal of Financial Economics 24, 289-318. Jagannathan, R. and Z. Wang, 1996, The Conditional CAPM and the CrossSection of Expected Returns, Journal of Finance 51, 3-53. Jagannathan, R. and T. Ma, 2003, Risk Reduction in Large Portfolios: A Role for Portfolio Weight Constraints, Journal of Finance 58, 1651-1683. Merton, R.C, 1980, On Estimating the Expected Return on the Market: An Exploratory Investigation, Journal of Financial Economics 8, 323-361. Nelson, D.B, 1992, Filtering and Forecasting with Misspecied ARCH Models I: Getting the Right Variance with the Wrong Model, Journal of Econometrics 52, 61-90. Newey, W.K. and K.D. West, 1987, A Simple, Positive Semi-Denite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix, Econometrica 55, 703-708. Scholes, M. and J. Williams, 1977, Estimating Betas from Nonsynchronous Data, Journal of Financial Economics 5, 309-327. White, H., 1980, A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity, Econometrica 48, 817-838.

19

Table 1

Stock

AA AXP BA CAT C DD DIS EK GE GM HD HON HWP IBM INTC IP JNJ JPM KO MCD MMM MO MRK MSFT PG SBC T UTX WMT XON SP

Mean of unfiltered return 10 2 -0.0002 0.0000 -0.0004 0.0010 0.0000 0.0005 -0.0005 0.0003 0.0002 -0.0015 0.0002 0.0007 -0.0003 -0.0005 0.0004 0.0001 0.0004 0.0001 0.0009 0.0006 -0.0000 -0.0002 0.0008 0.0010 0.0016 0.0009 -0.0001 0.0008 -0.0002 0.0005 0.0003

Mean of filtered return 10 2 0.0000 0.0000 -0.0000 -0.0000 0.0000 0.0000 0.0000 -0.0000 -0.0000 0.0000 -0.0000 -0.0000 -0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 -0.0000 0.0000 0.0000 0.0000 0.0000 -0.0000 -0.0000 -0.0000 -0.0000 -0.0000 -0.0000 0.0000

First autocorrelation of unfiltered return -0.0842 -0.1677 -0.1409 -0.0351 -0.1470 -0.1464 -0.1509 -0.1063 -0.1060 -0.1558 -0.2031 -0.1827 -0.0296 -0.0972 0.0802 -0.1240 -0.1314 -0.1104 -0.1698 -0.1804 -0.1013 -0.1725 -0.1784 0.0998 -0.1047 -0.1505 -0.1565 -0.0299 -0.2078 -0.1313 -0.0377

First auto- Second autocorrelation correlation of of filtered filtered return return -0.0003 -0.0040 -0.0061 -0.0337 -0.0033 -0.0222 -0.0006 -0.0104 -0.0015 -0.0099 -0.0035 -0.0243 -0.0060 - 0.0384 -0.0004 -0.0032 -0.0025 -0.0244 -0.0011 -0.0054 -0.0029 -0.0144 -0.0061 -0.0308 -0.0003 -0.0110 -0.0002 0.0001 -0.0023 0.0292 -0.0019 -0.0164 -0.0022 -0.0159 -0.0005 -0.0030 -0.0021 -0.0107 -0.0048 -0.0246 -0.0013 -0.0090 -0.0037 -0.0192 -0.0040 -0.0209 -0.0040 0.0385 -0.0024 -0.0219 -0.0020 -0.0126 -0.0018 -0.0087 0.0000 -0.0050 -0.0062 -0.0266 -0.0040 -0.0287 -0.0016 -0.0391

Variance of filtered return 10 4 0.0303 0.0481 0.0330 0.0315 0.0548 0.0352 0.0355 0.0260 0.0256 0.0327 0.0506 0.0460 0.0391 0.0320 0.0325 0.0329 0.0322 0.0262 0.0286 0.0338 0.0250 0.0371 0.0341 0.0264 0.0303 0.0292 0.0258 0.0236 0.0540 0.0214 0.0084

Variance of daily return 10 4 2.4578 3.1894 2.2676 2.4326 4.5243 2.5227 2.5723 2.0993 1.8102 2.8193 3.8108 3.1032 3.0407 2.9616 2.8245 2.4508 2.2533 2.4331 2.3299 2.2575 1.5981 2.6625 2.6497 2.2605 2.0422 2.2165 2.1200 1.5457 3.8889 1.5739 0.6635

Note: The summary statistics are based on the five-minute returns within the day as detailed in the main text. The sample covers the period from January 2,1993 through December 31,1998, for a total of 1514 daily observations. The daily return series is constructed by the summation of all the 72 intraday five-minute returns in the same day. In all the above calculations of variances and autocorrelations, we take zero as the estimate of the mean. The last row, SP, represents the market index.

Table 2

Stock

AA AXP BA CAT C DD DIS EK GE GM HD HON HWP IBM INTC IP JNJ JPM KO MCD MMM MO MRK MSFT PG SBC T UTX WMT XON SP

Mean of overnight return 10 2 0.0689 0.1074 0.0679 0.0189 0.1166 0.0313 0.0853 0.0462 0.0974 0.1718 0.0736 0.0148 0.1364 0.1699 0.1309 0.0210 0.0545 0.0398 0.0194 0.0341 0.0418 0.0814 0.0309 0.1001 -0.0233 0.0170 0.0712 0.0511 0.0832 0.0398 0.0339

Variance of overnight return 10 4 0.7929 1.0661 1.4722 1.1659 1.5864 0.8491 1.1316 1.3982 0.5872 0.9830 1.0874 0.7993 1.6435 1.1760 2.1126 0.7864 0.7083 0.6974 0.6171 0.7815 0.6226 1.2860 0.8380 1.3155 0.6258 0.6153 0.7993 0.7283 1.0444 0.4220 0.2188

First autocorrelation of overnight return 0.0379 -0.0207 0.0860 0.0278 -0.0295 0.0378 -0.0042 0.0588 0.0488 0.0719 0.0254 -0.0272 0.0218 0.0451 0.0428 0.0370 0.0446 -0.0284 0.0939 0.0794 0.0119 0.0407 0.0465 0.0022 0.0646 0.0004 0.0370 -0.0275 0.0301 0.0135 -0.0142

Variance of intraday return (unfiltered) 10 4 2.0628 2.2066 1.6738 2.2735 3.2781 1.8407 1.8602 1.6766 1.4532 2.0204 2.3716 2.0653 2.8663 2.4278 3.2863 1.8734 1.7005 1.9296 1.6001 1.5076 1.2965 1.8433 1.7772 2.7263 1.6527 1.5985 1.5135 1.4590 2.3966 1.1894 0.6164

Variance of close-to-close return 10 4 2.8738 3.5078 3.2057 3.4666 4.9925 2.6115 2.8566 3.2613 1.9198 2.9886 3.5445 2.8172 4.8331 3.7303 5.4613 2.6720 2.3664 2.7001 2.1059 2.2375 1.9094 3.4030 2.8037 4.1856 2.2794 2.2906 2.4976 2.1189 3.3783 1.6003 0.8259

Variance ratio

3.0997 2.9917 1.5403 2.0864 2.8519 2.9710 2.2731 1.5014 3.0826 2.8680 3.5044 3.8824 1.8501 2.5183 1.3370 3.1164 3.1811 3.4888 3.7758 2.8887 2.5669 2.0703 3.1620 1.7184 3.2632 3.6026 2.6525 2.1223 3.7234 3.7299 3.0325

Note: The sample covers the period from January 2,1993 through December 31,1998, for a total of 1514 daily observations. The overnight return is the return from close of the previous trading day to open of the subsequent trading day, adjusted for dividends and splits. The intraday return series is constructed by the summation of all the 72 intraday five-minute returns in the same day. The close-to-close return is the raw (unfiltered) return from close of the previous trading day to close of the subsequent trading day. The variance ratio is the ratio of the variance of the intraday return (from open to close) to the variance of the overnight return. In the above calculations of variances and autocorrelations, we take the sample mean as the estimate of the mean in column 3 and 4, while taking zero as the estimate of the mean in column 5 and 6. The last row, SP, represents the market index.

Stock +5 +4 +3

AA AXP BA CAT C DD DIS EK GE GM HD HON HWP IBM INTC IP

-0.0175 (-2.4049) 0.0412 (2.6506)

+2 0.0521 (6.7515) 0.0434 (3.6363) 0.0338 (2.8427)

0.0713 (4.5987)

0.0243 (3.0223)

0.0663 (7.3216) 0.1187 (9.4457) 0.0499 (3.6046)

0.0457 (5.0148) 0.0320 (3.0655)

Table 3 Leads and Lags and their T-statistics +1 0 -1 0.3127 0.4385 (34.4983) (32.5552) 0.3989 0.7367 (25.4546) (61.5229) 0.3056 0.5057 (21.8313) (36.5221) 0.3618 0.5685 (31.4930) (38.4578) 0.3973 0.8113 (29.2138) (48.6404) 0.3806 0.6912 (36.8746) (35.0386) 0.3967 0.6118 (24.0321) (49.2944) 0.2881 0.4764 (30.9826) (37.6507) 0.3309 0.8402 (32.9083) (49.1187) 0.3761 0.5042 (30.4522) (52.0384) 0.4635 0.6123 -0.0336 (24.5591) (51.1197) (-2.4311) 0.4014 0.5940 (21.9199) (41.4533) 0.3814 0.7958 (27.3169) (55.2805) 0.2980 0.7726 0.0418 (21.3948) (59.7972) (3.9683) 0.2251 0.7514 0.0644 (21.5920) (48.3191) (6.1463) 0.3099 0.5160 (26.8859) (45.8022)

-2

-3

-4

-5

-0.0319 (-2.6740)

-0.0302 (-2.8419) -0.0249 (-2.1422) -0.0233 (-2.9711) -0.0537 (-3.9588)

-0.0291 (-2.3127)

-0.0278 (-2.0497)

-0.0318 (-2.9710) 0.0183 (2.0287) 0.0299 (3.2443) 0.0187 (2.1431) 0.0271 (2.9018)

JNJ JPM KO MCD MMM MO MRK MSFT PG SBC T UTX WMT XON
-0.0186 (-2.0991) 0.0236 (2.5937) 0.0190 (2.2793) -0.0231 (-2.6247) 0.0183 (2.0818)

0.0417 (3.9316) 0.0294 (3.0575) 0.0623 (5.3354) 0.0898 (10.2444) 0.0242 (2.9689) 0.0425 (4.7579) 0.0541 (6.1473) 0.0406 (4.7299)

0.4139 (32.9897) 0.2990 (16.1446) 0.3694 (30.7793) 0.3487 (24.2226) 0.3080 (29.1879) 0.3461 (27.5343) 0.3401 (25.7406) 0.1885 (16.8580) 0.2975 (24.5609) 0.0893 0.3948 (10.1051) (45.6727) 0.0382 0.3417 (3.6048) (26.7139) 0.0193 0.2682 (2.1700) (26.4031) 0.1315 0.4616 (9.9822) (28.2739) -0.0237 0.2700 (-2.6171) (24.4817)

0.6525 (40.8428) 0.6869 (66.0743) 0.6952 (57.6183) 0.4767 (50.7802) 0.5835 (58.4202) 0.5575 (41.0191) 0.6806 (47.9408) 0.7019 (59.2917) 0.8237 (52.0585) 0.4853 (40.5543) 0.5200 (40.3688) 0.4734 (37.8562) 0.6638 (43.0355) 0.6756 (40.7108)

-0.0221 (-2.3515) 0.0198 (2.0834) -0.0208 (-2.3209) -0.0224 (-2.6108) -0.0212 -0.0230 (-2.2289) (-2.7960)

-0.0342 (-3.5771) 0.0445 (4.3783) -0.0211 (-1.9777) -0.0446 (-4.9294) 0.0186 (2.2961)

0.0199 (2.3628)

-0.0227 (-2.3393)

-0.0236 (-2.8351)

-0.0188 (-2.1355)

Note: The summary statistics are based on the five-minute returns within the day as detailed in the main text. The sample covers the period from January 2,1993 through December 31,1998, for a total of 1514 daily observations. From the left to the right, are OLS regression estimators of lead and lag security betas up to 5 periods. White t-statistics are reported in parentheses below the corresponding estimates. To save space, we only report the estimates which are significant at the 5% level.

Table 4 Stock Beta using Beta daily returns using from CRSP monthly returns 0.8301 0.8387 1.3270 1.2739 0.8512 0.9662 0.7591 1.0087 1.7401 1.6843 0.7566 0.9479 1.0388 1.0069 0.3334 0.6918 1.0870 1.1763 0.8946 0.9486 0.8470 1.2443 1.2001 1.0224 1.3718 1.1987 1.2187 1.0754 1.3271 1.3669 1.0279 0.8278 0.9791 0.9617 1.1806 1.1490 1.0054 1.0356 1.0437 0.8547 0.6489 0.7468 0.8586 0.8716 1.1145 1.0295 1.2478 1.3018 0.9408 1.0178 0.7045 0.7786 0.9122 0.8628 1.2518 0.9187 0.9295 1.1323 0.6218 0.7150 0.2166 0.2740 ScholesWilliams Beta 0.8187 1.4255 0.9982 1.1072 2.0110 1.0905 0.9797 0.7991 1.1668 1.0184 1.3502 1.2223 1.1307 1.0464 1.1034 0.9490 0.9438 1.2563 0.9754 0.8061 0.7332 0.7535 1.0345 1.2323 0.8399 0.5807 0.7092 1.0862 1.0732 0.6509 0.2751 Beta using 5minute returns 0.8082 1.1643 0.8518 0.9138 1.3068 1.0504 0.9847 0.7499 1.1247 0.9460 1.1569 0.9974 1.1252 1.1071 1.0977 0.8356 1.0804 1.0097 1.1027 0.8963 0.8561 0.9344 1.0535 0.9797 1.0748 0.9256 0.9004 0.7284 1.2493 0.8761 0.1373 Overnight Beta Beta using intraday and overnight returns 0.7954 1.1685 0.8989 0.9651 1.4272 1.0157 0.9907 0.7313 1.1363 0.9495 1.1735 1.0225 1.1276 1.0723 1.1463 0.8442 1.0237 1.0373 1.0541 0.9030 0.8194 0.9290 0.9975 1.0113 1.0442 0.8796 0.8766 0.7905 1.2023 0.7852 0.1519

AA AXP BA CAT C DD DIS EK GE GM HD HON HWP IBM INTC IP JNJ JPM KO MCD MMM MO MRK MSFT PG SBC T UTX WMT XON Dispersion

0.7566 1.1813 1.0416 1.1208 1.7922 0.9105 1.0087 0.6750 1.1716 0.9603 1.2239 1.0988 1.1348 0.9666 1.2938 0.8704 0.8516 1.1210 0.9067 0.9235 0.7082 0.9128 0.8278 1.1070 0.9513 0.7403 0.8044 0.9787 1.0598 0.5094 0.2344

Note: The second and third columns are betas calculated based on CRSP daily and monthly returns respectively, where we use returns on S&P 500 Composite Index as the market index proxy. The ScholesWilliams beta estimator is included in column 4 which is used to overcome the errors-in-variables problem caused by nonsynchronous trading. Column 5 is the beta estimated from five-minute returns where we take the security beta as the sum of lead 2 period to lag 2 period betas. Column 6 is the beta estimated from overnight returns where we take the overnight return as the log difference between the price at 10:00 EST and 16:00 EST in the previous day. Column 7 is the beta estimated from five-minute returns and overnight returns, following Proposition 8. The last row is the standard deviation of beta estimates of the thirty DJIA stocks estimated with different return series and methods.

Table 5 Stock AA AXP BA CAT C DD DIS EK GE GM HD HON HWP IBM INTC IP JNJ JPM KO MCD MMM MO MRK MSFT PG SBC T UTX WMT XON Minimum 0.5399 0.7585 0.5152 0.6190 0.9181 0.6238 0.6124 0.4606 0.7985 0.6398 0.7181 0.6155 0.7200 0.8501 0.7858 0.4903 0.6435 0.7599 0.8455 0.5823 0.6623 0.5105 0.7495 0.7359 0.6627 0.6038 0.6233 0.5562 0.7868 0.2788 Maximum 1.5919 1.7347 1.3196 1.7291 2.4254 1.6151 1.8313 1.1751 1.3168 2.1268 1.9378 1.2653 2.1075 1.8828 2.3820 1.4697 2.1133 1.4302 1.4669 1.4501 1.2637 1.5205 1.9014 2.2252 1.6685 1.6337 1.3355 1.0688 2.0055 1.4475 Mean 0.9608 1.2038 0.9573 1.0656 1.3007 1.1177 1.1027 0.8568 1.1416 1.1425 1.2780 0.9306 1.2866 1.2308 1.3309 0.9608 1.1985 1.0689 1.1410 1.0040 0.9054 1.0488 1.1650 1.1682 1.1457 1.0153 0.9804 0.7622 1.2818 0.9146 Variance 0.0912 0.0511 0.0480 0.1075 0.0970 0.0549 0.1015 0.0396 0.0158 0.1791 0.1148 0.0425 0.1074 0.0696 0.1923 0.0614 0.0992 0.0378 0.0287 0.0593 0.0269 0.0584 0.0750 0.1274 0.0526 0.0680 0.0515 0.0202 0.1048 0.0534 MSE with AR(1) 0.0459 0.0487 0.0451 0.0666 0.0956 0.0431 0.0832 0.0243 0.0136 0.0805 0.0495 0.0392 0.0906 0.0654 0.1465 0.0388 0.0298 0.0380 0.0266 0.0428 0.0234 0.0337 0.0311 0.1037 0.0520 0.0530 0.0349 0.0198 0.0892 0.0354 First autocorrelation 0.7320 0.3594 0.3614 0.6520 0.3101 0.3630 0.3974 0.6631 0.4461 0.7547 0.7723 0.3941 0.4767 0.3632 0.5508 0.6096 0.7455 0.2259 0.2746 0.5818 0.4511 0.6550 0.6608 0.5008 0.3107 0.5053 0.5613 0.2711 0.4683 0.6288

Note: The second and third columns are minimum and maximum beta of the 24 quarterly betas from 1993 to 1998 respectively. The fourth and fifth columns are the mean and variance of the quarterly betas series of all the thirty stocks. Column 6 is the MSE with a AR(1) model. The last column is the first autocorrelation of these quarterly betas.

Table 6 Stock Constant Beta Model 0.3820 0.2646 0.3218 0.3081 0.4419 0.3545 0.3976 0.2991 0.1813 0.3875 0.2764 0.3142 0.2104 0.2243 0.2810 0.2583 0.4738 0.2669 0.3031 0.3528 0.3193 0.4144 0.3761 0.1991 0.4572 0.2435 0.2170 0.2523 0.2702 0.3405 ARMA(1,1) AR(1) MA(1) In sample chosen Models 0.2155 0.2518 0.2770 0.2291 0.3540 0.2705 0.2517 0.1896 0.1869 0.1661 0.3031 0.2793 0.2411 0.2074 0.2216 0.2127 0.2073 0.2554 0.2221 0.2103 0.2141 0.1423 0.2432 0.2062 0.3159 0.2601 0.2669 0.2523 0.2508 0.2162 Error Difference 0.2039 0.0153 0.0788 0.0918 0.0638 0.1328 0.1459 0.1095 -0.0065 0.2214 -0.0267 0.0302 -0.0161 0.0169 0.0817 0.0452 0.2665 0.0073 0.1414 0.1525 0.1160 0.2721 0.1809 -0.0078 0.1683 -0.0166 -0.0450 0.0028 0.0194 0.1243

AA AXP BA CAT C DD DIS EK GE GM HD HON HWP IBM INTC IP JNJ JPM KO MCD MMM MO MRK MSFT PG SBC T UTX WMT XON

0.1781* 0.2493 0.2430* 0.2163* 0.3781 0.2217* 0.2517* 0.1896* 0.1878 0.1661* 0.3031* 0.2840* 0.2265 0.2074 0.1993 0.2131* 0.2073* 0.2596 0.1617* 0.2003* 0.2033* 0.1423* 0.1952* 0.2069 0.2889 0.2601 0.2620* 0.2495 0.2508 0.2162

0.2442 0.2471 0.2896 0.2355 0.3720 0.2712 0.3089 0.2134 0.1888 0.2060 0.3117 0.3078 0.2376 0.2338 0.2127 0.2137 0.2547 0.2526 0.2221 0.2493 0.2413 0.2654 0.2541 0.2062 0.3159 0.2420 0.2392 0.2490 0.2649 0.2261

0.3043 0.2518 0.2965 0.2759 0.3913 0.3019 0.3401 0.2475 0.1869 0.3001 0.2918 0.3086 0.2394 0.2354 N/A 0.2243 0.3344 0.2554 0.2445 0.2961 0.2638 0.3005 0.2852 0.2088 0.3698 0.2246 0.2267 0.2495 0.2690 0.2669

Note: This table gives the square root errors of the monthly beta forecasts of different models. The second column is for constant beta model. The third column is for ARMA(1,1), where the numbers with * indicates that there is a unit root and an ARIMA(0,1,1) is used. Column 4 and 5 are for AR(1) and MA(1), respectively. N/A indicates that the estimation algorithm of MA(1) did not converge after 50 iterations for stock INTC. Column 6 is the error series obtained from using in-sample chosen models. These in-sample chosen models may be ARMA(1,1), AR(1), MA(1) or other higher order ARMA models. The last column is equal to the difference of column 2 and 3, which measures the difference of SRE between constant beta model and ARMA(1,1) model.

Table 7 Stock STD (realized monthly betas-HF) 0.0867 0.0564 0.0661 0.0770 0.0715 0.0630 0.0693 0.0675 0.0444 0.0790 0.0702 0.0773 0.0965 0.0742 0.1044 0.0746 0.0633 0.0542 0.0654 0.0549 0.0557 0.0818 0.0725 0.0957 0.0724 0.0584 0.0763 0.0585 0.0713 0.0400 STD (constant beta from monthly returns) 0.0836 0.0572 0.0673 0.0790 0.0705 0.0635 0.0701 0.0675 0.0427 0.0780 0.0684 0.0773 0.0947 0.0750 0.1018 0.0739 0.0638 0.0553 0.0665 0.0570 0.0553 0.0822 0.0738 0.0908 0.0725 0.0577 0.0760 0.0503 0.0706 0.0394 STD (3-month tbill, timevarying betas) 0.0865 0.0565 0.0661 0.0770 0.0717 0.0631 0.0693 0.0676 0.0445 0.0788 0.0700 0.0773 0.0963 0.0742 0.1045 0.0746 0.0630 0.0541 0.0653 0.0551 0.0558 0.0817 0.0724 0.0956 0.0725 0.0583 0.0764 0.0583 0.0713 0.0398 STD (3-month t-bill, constant beta) 0.0836 0.0573 0.0672 0.0790 0.0709 0.0635 0.0701 0.0673 0.0428 0.0780 0.0684 0.0773 0.0948 0.0751 0.1020 0.0738 0.0638 0.0552 0.0665 0.0570 0.0553 0.0822 0.0737 0.0912 0.0724 0.0577 0.0760 0.0503 0.0706 0.0391 STD (1-year bond, timevarying betas) 0.0865 0.0565 0.0661 0.0770 0.0717 0.0631 0.0693 0.0676 0.0445 0.0788 0.0700 0.0773 0.0963 0.0742 0.1046 0.0746 0.0630 0.0541 0.0653 0.0551 0.0558 0.0817 0.0724 0.0956 0.0725 0.0583 0.0764 0.0583 0.0713 0.0398 STD (1-year bond, constant beta) 0.0836 0.0573 0.0672 0.0790 0.0709 0.0635 0.0701 0.0672 0.0429 0.0780 0.0684 0.0773 0.0948 0.0751 0.1020 0.0738 0.0638 0.0552 0.0665 0.0570 0.0553 0.0822 0.0737 0.0912 0.0724 0.0577 0.0760 0.0503 0.0706 0.0391

AA AXP BA CAT C DD DIS EK GE GM HD HON HWP IBM INTC IP JNJ JPM KO MCD MMM MO MRK MSFT PG SBC T UTX WMT XON

Note: This table gives the standard deviation of the monthly noise series from 1993.01 to 2000.06 if we use different beta estimates. The second column is for realized monthly beta estimates using high-frequency data. The third column is for constant beta where we use the regression of the monthly returns of a stock on a constant and market index to get the constant beta. Column 4 and 5 are similar to column 2 and 3, except that we use the excess return to replace the raw return series where the proxy for the risk free rate is 3-month Tbill. In column 6 and 7, we use 1-year government bond as the proxy for the risk free asset.

Table 8 Stock Var( t ) Var ( t ) Var( t .rm,t )

Cov( t .rm ,t , t )

Cov( t .rm ,t , .rm,t )

AA AXP BA CAT C DD DIS EK GE GM HD HON HWP IBM INTC IP JNJ JPM KO MCD MMM MO MRK MSFT PG SBC T UTX WMT XON

0.1241 0.0856 0.0748 0.1342 0.1481 0.0866 0.1360 0.0632 0.0296 0.1928 0.1325 0.1026 0.1339 0.0938 0.2067 0.0922 0.1447 0.0621 0.0614 0.0916 0.0595 0.1134 0.1093 0.1337 0.1136 0.0945 0.0768 0.0421 0.1422 0.0688

0.0075 0.0031 0.0044 0.0060 0.0050 0.0040 0.0049 0.0046 0.0019 0.0063 0.0049 0.0060 0.0092 0.0054 0.0104 0.0056 0.0040 0.0030 0.0043 0.0031 0.0031 0.0067 0.0053 0.0088 0.0053 0.0034 0.0059 0.0033 0.0051 0.0016

0.0002 0.0001 0.0001 0.0001 0.0003 0.0001 0.0002 0.0004 0.0000 0.0002 0.0002 0.0002 0.0001 0.0001 0.0003 0.0002 0.0002 0.0001 0.0001 0.0001 0.0001 0.0002 0.0001 0.0006 0.0005 0.0002 0.0001 0.0008 0.0002 0.0003

-0.0005 0.0000 0.0000 0.0001 -0.0002 -0.0000 -0.0000 -0.0002 -0.0001 -0.0001 -0.0002 -0.0001 -0.0002 -0.0000 -0.0005 -0.0002 -0.0000 -0.0000 -0.0000 0.0000 -0.0001 -0.0001 0.0000 -0.0006 -0.0002 -0.0001 -0.0001 -0.0008 -0.0001 -0.0002

-0.0004 -0.0000 0.0000 -0.0000 -0.0007 0.0002 0.0001 0.0002 -0.0001 0.0000 0.0002 -0.0002 -0.0000 0.0000 0.0001 -0.0005 0.0002 -0.0003 0.0003 -0.0001 0.0002 0.0002 0.0002 -0.0013 0.0004 0.0002 -0.0001 -0.0015 0.0002 0.0002

Note: Here t is the noise series as in equation (7). t = t , where t is the timevarying beta estimate at month t from the high-frequency data, and is the constant beta estimate using the regression of the monthly returns of a stock in the full sample period on a constant and market index . rm,t = rm ,t r f ,t , where rm ,t is the return of the market index at month t, and r f ,t is the return of the risk free rate at month t. we use the 3 month T-bill as the proxy for the riskless asset.

Table 9 Stock STD (ARMA(1,1) forecast beta) STD (average beta estimate from monthly betas) 0.0285 0.0211 0.0240 0.0266 0.0188 0.0250 0.0266 0.0197 0.0142 0.0223 0.0213 0.0259 0.0306 0.0241 0.0257 0.0286 0.0196 0.0194 0.0246 0.0221 0.0212 0.0292 0.0204 0.0234 0.0276 0.0230 0.0269 0.0224 0.0240 0.0201 STD (beta estimate from past monthly returns) 0.0287 0.0211 0.0238 0.0263 0.0196 0.0241 0.0261 0.0184 0.0142 0.0220 0.0217 0.0261 0.0307 0.0239 0.0261 0.0289 0.0189 0.0194 0.0238 0.0220 0.0206 0.0286 0.0200 0.0234 0.0269 0.0231 0.0268 0.0237 0.0244 0.0191 STD 3-month Tbill, ARMA(1,1) 0.0277 0.0211 0.0235 0.0262 0.0187 0.0241 0.0257 0.0189 0.0142 0.0219 0.0213 0.0259 0.0305 0.0240 0.0255 0.0280 0.0188 0.0194 0.0237 0.0217 0.0207 0.0286 0.0201 0.0233 0.0272 0.0230 0.0269 0.0224 0.0240 0.0194 STD 1-year bond, ARMA(1,1)

AA AXP BA CAT C DD DIS EK GE GM HD HON HWP IBM INTC IP JNJ JPM KO MCD MMM MO MRK MSFT PG SBC T UTX WMT XON

0.0277 0.0211 0.0235 0.0262 0.0187 0.0241 0.0257 0.0189 0.0142 0.0219 0.0213 0.0259 0.0305 0.0240 0.0255 0.0280 0.0188 0.0194 0.0237 0.0217 0.0207 0.0286 0.0201 0.0233 0.0272 0.0230 0.0269 0.0224 0.0240 0.0194

0.0277 0.0211 0.0235 0.0262 0.0187 0.0241 0.0257 0.0189 0.0142 0.0219 0.0213 0.0259 0.0305 0.0240 0.0255 0.0280 0.0188 0.0194 0.0237 0.0217 0.0207 0.0286 0.0201 0.0233 0.0272 0.0230 0.0269 0.0224 0.0240 0.0194

Note: This table gives the standard deviation of the daily noise series from 01/04/1999 to 06/30/2000 if we use different beta forecasts. The second column is for the forecasted monthly betas using ARMA(1,1) model. The third column is for constant beta forecasts using the mean of the previous monthly realized betas. In column 4, we use the rolling regression of the monthly returns of a stock in the past six years on a constant and market index to get the beta series and use the beta as the forecast of the beta in the next month. Column 5 and 6 are similar to column 2, except that we use the excess return to replace the raw return series where the proxy for the risk free asset is 3-month T-bill and 1-year government bond, respectively. Using excess return to replacing raw return has no influence to the result, thus column 5 and 6 are totally the same as column 2.