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Article

Flexible Time-Varying Betas in a Novel Mixture Innovation Factor Model with Latent Threshold

1
Department of Economics, Eastern Mediterranean University, Northern Cyprus, via Mersin 10, Famagusta 99450, Turkey
2
Department of Economics and Finance, Southern Illinois University Edwardsville, Edwardsville, IL 62026-1102, USA
3
Faculty of Economics Administrative and Social Sciences, Istanbul Gelisim University, Istanbul 34310, Turkey
*
Author to whom correspondence should be addressed.
Academic Editor: Rafael Benítez
Mathematics 2021, 9(8), 915; https://doi.org/10.3390/math9080915
Received: 30 March 2021 / Revised: 13 April 2021 / Accepted: 14 April 2021 / Published: 20 April 2021
(This article belongs to the Special Issue Application of Mathematical Methods in Financial Economics)
This paper introduces a new methodology to estimate time-varying alphas and betas in conditional factor models, which allows substantial flexibility in a time-varying framework. To circumvent problems associated with the previous approaches, we introduce a Bayesian time-varying parameter model where innovations of the state equation have a spike-and-slab mixture distribution. The mixture distribution specifies two states with a specific probability. In the first state, the innovation variance is set close to zero with a certain probability and parameters stay relatively constant. In the second state, the innovation variance is large and the change in parameters is normally distributed with mean zero and a given variance. The latent state is specified with a threshold that governs the state change. We allow a separate threshold for each parameter; thus, the parameters may shift in an unsynchronized manner such that the model moves from one state to another when the change in the parameter exceeds the threshold and vice versa. This approach offers great flexibility and nests a plethora of other time-varying model specifications, allowing us to assess whether the betas of conditional factor models evolve gradually over time or display infrequent, but large, shifts. We apply the proposed methodology to industry portfolios within a five-factor model setting and show that the threshold Capital Asset Pricing Model (CAPM) provides robust beta estimates coupled with smaller pricing errors compared to the alternative approaches. The results have significant implications for the implementation of smart beta strategies that rely heavily on the accuracy and stability of factor betas and yields. View Full-Text
Keywords: time-varying beta; risk premium; asset pricing; bayesian estimation; thresholds time-varying beta; risk premium; asset pricing; bayesian estimation; thresholds
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MDPI and ACS Style

Balcilar, M.; Demirer, R.; Bekun, F.V. Flexible Time-Varying Betas in a Novel Mixture Innovation Factor Model with Latent Threshold. Mathematics 2021, 9, 915. https://doi.org/10.3390/math9080915

AMA Style

Balcilar M, Demirer R, Bekun FV. Flexible Time-Varying Betas in a Novel Mixture Innovation Factor Model with Latent Threshold. Mathematics. 2021; 9(8):915. https://doi.org/10.3390/math9080915

Chicago/Turabian Style

Balcilar, Mehmet, Riza Demirer, and Festus V. Bekun. 2021. "Flexible Time-Varying Betas in a Novel Mixture Innovation Factor Model with Latent Threshold" Mathematics 9, no. 8: 915. https://doi.org/10.3390/math9080915

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