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Unexplained factors and their effects on second pass R-squared’s

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  • Frank Kleibergen
  • Zhaoguo Zhan

    (Tsinghua University)

Abstract

We construct the large sample distributions of the OLS and GLS R^2’s of the second pass regression of the Fama-MacBeth (1973) two pass procedure when the observed proxy factors are minorly correlated with the true unobserved factors. This implies an unexplained factor structure in the first pass residuals and, consequently, a large estimation error in the estimated beta’s which is spanned by the beta’s of the unexplained true factors. The average portfolio returns and the estimation error of the estimated beta’s are then both linear in the beta’s of the unobserved true factors which leads to possibly large values of the OLS R2 of the second pass regression. These large values of the OLS R2 are not indicative of the strength of the relationship. Our results question many empirical findings that concern the relationship between expected portfolio returns and (macro-)economic factors.

Suggested Citation

  • Frank Kleibergen & Zhaoguo Zhan, 2014. "Unexplained factors and their effects on second pass R-squared’s," UvA-Econometrics Working Papers 14-05, Universiteit van Amsterdam, Dept. of Econometrics.
  • Handle: RePEc:ame:wpaper:1405
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    References listed on IDEAS

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    Cited by:

    1. Khalaf, Lynda & Schaller, Huntley, 2016. "Identification and inference in two-pass asset pricing models," Journal of Economic Dynamics and Control, Elsevier, vol. 70(C), pages 165-177.
    2. Gospodinov, Nikolay & Kan, Raymond & Robotti, Cesare, 2019. "Too good to be true? Fallacies in evaluating risk factor models," Journal of Financial Economics, Elsevier, vol. 132(2), pages 451-471.
    3. Baltzer, Markus & Koehl, Alexandra & Reitz, Stefan, 2019. "Procyclical leverage in Europe and its role in asset pricing," Discussion Papers 10/2019, Deutsche Bundesbank.
    4. Joachim Freyberger & Andreas Neuhierl & Michael Weber, 2017. "Dissecting Characteristics Nonparametrically," NBER Working Papers 23227, National Bureau of Economic Research, Inc.
    5. Antoine A. Djogbenou, 2017. "Model Selection In Factor-augmented Regressions With Estimated Factors," Working Paper 1391, Economics Department, Queen's University.
    6. 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.
    7. Stanislav Anatolyev & Anna Mikusheva, 2018. "Limit Theorems for Factor Models," Papers 1807.06338, arXiv.org.
    8. Beaulieu, Marie-Claude & Gagnon, Marie-Hélène & Khalaf, Lynda, 2016. "Less is more: Testing financial integration using identification-robust asset pricing models," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 45(C), pages 171-190.

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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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