Reward Beta Approach: A Review

Abstract

This article reviews an alternative method to estimate the expected returns, incorporating the Capital Asset Pricing Model (CAPM) theory and the empiricism of the Arbitrage Pricing Theory (APT). The proposal of the Reward Beta Approach, discussed by Bornholt (2007), derives from a class of medium risk measures based on the APT, and is consistent with the expected utility theory and with the risk aversion hypothesis. Beyond the demonstration of the Reward Beta Approach, this research makes an empirical evaluation of this model in comparison to the CAPM and the Fama and French Three-Factor model. Based on the two-step test methodology: 1) estimation of the models' parameters through time series regressions in an ex-ante sample; 2) use of the parameters as explanatory variables in a cross section regression and ex-post sample; the CAPM and the Fama and French Three-Factor model were rejected. The Reward Beta Approach easily passed the two-step test and was consistently superior in the robustness analysis later developed.