Direct semi‐parametric estimation of fixed effects panel data varying coefficient models

In this paper, we present a new technique to estimate varying coefficient models of unknown form in a panel data framework where individual effects are arbitrarily correlated with the explanatory variables in an unknown way. The estimator is based on first differences and then a local linear regression is applied to estimate the unknown coefficients. To avoid a non‐negligible asymptotic bias, we need to introduce a higher‐dimensional kernel weight. This enables us to remove the bias at the price of enlarging the variance term and, hence, achieving a slower rate of convergence. To overcome this problem, we propose a one‐step backfitting algorithm that enables the resulting estimator to achieve optimal rates of convergence for this type of problem. It also exhibits the so‐called oracle efficiency property. We also obtain the asymptotic distribution. Because the estimation procedure depends on the choice of a bandwidth matrix, we also provide a method to compute this matrix empirically. The Monte Carlo results indicate the good performance of the estimator in finite samples.