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Two-pass estimation of risk premiums with multicollinear and near-invariant betas

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  • Ahn, Seung C.
  • Perez, M. Fabricio
  • Gadarowski, Christopher

Abstract

This paper investigates the reliability of the two-pass (TP) estimators of factor risk prices when betas (multifactor loadings) have high levels of cross-sectional correlation (multicollinearity) and/or when some of them have small cross-sectional variations (near-invariance). Our simulation results show the following. First, the TP estimators can have biases larger than 100% of true risk prices when data are generated by the betas with high levels of multicollinearity and invariance that can be observed from actual data. Second, the t-tests for hypotheses related to risk prices and pricing intercepts have only limited power. The levels of multicollinearity and invariance of betas can vary depending on the assets and sample periods used in estimation. Thus, we propose use of two pre-diagnostic statistics to measure these levels. Many previous studies have investigated the finite-sample properties of the TP estimators using the data generated with the estimated betas from actual data. Our results indicate that simulation outcomes can lead to quite different conclusions, depending on the levels of multicollinearity and invariance of the betas used to generate the data.

Suggested Citation

  • Ahn, Seung C. & Perez, M. Fabricio & Gadarowski, Christopher, 2013. "Two-pass estimation of risk premiums with multicollinear and near-invariant betas," Journal of Empirical Finance, Elsevier, vol. 20(C), pages 1-17.
  • Handle: RePEc:eee:empfin:v:20:y:2013:i:c:p:1-17
    DOI: 10.1016/j.jempfin.2012.10.004
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    Cited by:

    1. Annaert, Jan & De Ceuster, Marc & Verstegen, Kurt, 2013. "Are extreme returns priced in the stock market? European evidence," Journal of Banking & Finance, Elsevier, vol. 37(9), pages 3401-3411.
    2. Seung C. Ahn & Alex R. Horenstein, 2017. "Asset Pricing and Excess Returns over the Market Return," Working Papers 2017-12, University of Miami, Department of Economics.
    3. Michael Curran & Adnan Velic, 2020. "The CAPM, National Stock Market Betas, and Macroeconomic Covariates: a Global Analysis," Open Economies Review, Springer, vol. 31(4), pages 787-820, September.

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    More about this item

    Keywords

    Two-pass; Fama–MacBeth; Cross-sectional regressions; Lineal factor model; Risk premium;
    All these keywords.

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C3 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables

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