Deleveraging CAPM: Asset Betas vs. Equity Betas

The classic estimates of CAPM equity betas are notoriously unstable. We assume that this is mainly due to changes of firm’s leverage over time. In order to take leverage into account, we propose a new approach where asset correlations among firms are pairwise constant, while equity correlations change over time as a function of the stochastic evolution of firms’ asset values. The paper closes with a simulation that helps to show the model’s features.