Instability and predictability of factor betas of industrial stocks: The Flexible Least Squares solutions

By using the Flexible Least Squares (FLS) method, this study traces out month-to-month alterations in factor betas. The time variation paths of factor betas reveal time-varying correlations between different factor betas. Moreover, the FLS method is found to be able to produce more accurate and stable forecasts of industry costs of equity than rolling regressions and other methods, in terms of smaller forecasting errors and standard deviation of forecasting errors, thanks to the better estimates of factor betas. (C) 2005 Board of Trustees of the University of Illinois. All rights reserved.