Investigating the merits of using a Kalman Filter in equity Beta estimation

Abstract

The concept of using alpha and beta to gauge the validity of an investment has been used extensively in both an academic as well as a professional setting. Despite its extensive use, the method of obtaining the alphas and betas estimates is deceptively simple and makes a number of unrealistic assumptions. This report aims to investigate the merits of using a Kalman Filter in equity beta and alpha estimation and thereby circumvent some of the issues of the more traditional approach. Final results show that the error improvements are non-existent or marginal at best. However, while the merits of the Kalman filtering technique is lackluster in this report, it makes a strong case further analysis into the area is warranted.