THE REACTIVE BETA MODEL

We present a reactive beta model that accounts for the leverage effect and beta elasticity. For this purpose, we derive a correlation metric for the leverage effect to identify the relation between the market beta and volatility changes. An empirical test based on the most popular market-neutral strategies is run from 2000 to 2015 with exhaustive data sets, including 600 U.S. stocks and 600 European stocks. Our findings confirm the ability of the reactive beta model to remove an important part of the bias from the beta estimation and from most popular market-neutral strategies. To examine the robustness of the reactive beta measurement, we conduct Monte Carlo simulations over seven market scenarios against five alternative methods. The results confirm that the reactive model significantly reduces the bias overall when financial markets are stressed.