Sorting, Firm Characteristics, and Time-varying Risk: An Econometric Analysis

We show that sorting reveals the time-varying market risk exposures of the firm-specific investment opportunity set. Sorting on the basis of firm characteristics uncovers information on firm-specific distress or growth, and this leads to more efficient estimation of conditional risk sensitivity. We demonstrate the effectiveness of the sorting methodology with an empirical exercise that tests the conditional capital asset pricing model (CAPM). When measured properly using sorting and firm characteristics, conditional betas, along with size and the book-market ratio, are significant drivers of expected returns. Copyright The Author 2007. Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.