Dynamic Sector Beta

A stock beta model describes the correlation between a stock and the general market and whether it amplifies () or dampens () market volatility. A dynamic factor model for stock beta describes how the betas evolve with time. A stock beta varies over the long run due to strategy, industry prospects, the composition of the market overall. The pandemic shock of 2020 highlights how a significant event can significantly change market betas: discretionary sector beta increased sharply, staples sector beta decreased sharply.

The observation equation describes how a sector's returns are a linear function of the market returns include a return differential the stock risk multiple . The stock multiple is time varying, evolving as a random walk according to the observation equation. This construct is a dynamic linear regression model where the fitted regression coefficients is time varying, a Kalman Filter and Smoother is used to fit the unobserved beta, where the innovations are drawn from the covariance matrix W.