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Fama–MacBeth two-pass regressions: Improving risk premia estimates

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  • Bai, Jushan
  • Zhou, Guofu

Abstract

In this paper, we provide the asymptotic theory for the widely used Fama and MacBeth (1973) two-pass risk premia estimates in the usual case of a large number of assets. We demonstrate analytically and using simulations that the standard OLS and GLS estimators can contain large bias when the time series sample size is small, but our proposed OLS and GLS estimators can reduce the bias significantly.

Suggested Citation

  • Bai, Jushan & Zhou, Guofu, 2015. "Fama–MacBeth two-pass regressions: Improving risk premia estimates," Finance Research Letters, Elsevier, vol. 15(C), pages 31-40.
    • Handle: RePEc:eee:finlet:v:15:y:2015:i:c:p:31-40
    DOI: 10.1016/j.frl.2015.08.001
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    1. Jianqing Fan & Yuan Liao & Martina Mincheva, 2013. "Large covariance estimation by thresholding principal orthogonal complements," Journal of the Royal Statistical Society Series B, Royal Statistical Society, vol. 75(4), pages 603-680, September.
    2. Raymond Kan & Cesare Robotti & Jay Shanken, 2013. "Pricing Model Performance and the Two‐Pass Cross‐Sectional Regression Methodology," Journal of Finance, American Finance Association, vol. 68(6), pages 2617-2649, December.
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    9. Jushan Bai & Shuzhong Shi, 2011. "Estimating High Dimensional Covariance Matrices and its Applications," Annals of Economics and Finance, Society for AEF, vol. 12(2), pages 199-215, November.
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    Cited by:

    1. Han, Yufeng & Zhou, Guofu & Zhu, Yingzi, 2016. "A trend factor: Any economic gains from using information over investment horizons?," Journal of Financial Economics, Elsevier, vol. 122(2), pages 352-375.
    2. Cavalcante-Filho, Elias & Chague, Fernando & De-Losso, Rodrigo & Giovannetti, Bruno, 2022. "US risk premia under emerging markets constraints," Journal of Empirical Finance, Elsevier, vol. 67(C), pages 217-230.
    3. Stefano Giglio & Dacheng Xiu, 2017. "Inference on Risk Premia in the Presence of Omitted Factors," NBER Working Papers 23527, National Bureau of Economic Research, Inc.
    4. José Luis Montiel Olea & Pietro Ortoleva & Mallesh Pai & Andrea Prat, 2021. "Competing Models," Working Papers 2021-89, Princeton University. Economics Department..
    5. Pesaran, M. Hashem & Smith, Ron P., 2023. "Arbitrage pricing theory, the stochastic discount factor and estimation of risk premia from portfolios," Econometrics and Statistics, Elsevier, vol. 26(C), pages 17-30.
    6. M. Hashem Pesaran & Run Smith, 2021. "Arbitrage pricing theory, the stochastic discount factor and estimation of risk premia in portfolios," BCAM Working Papers 2108, Birkbeck Centre for Applied Macroeconomics.
    7. M. Hashem Pesaran & Ron P. Smith, 2021. "Factor Strengths, Pricing Errors, and Estimation of Risk Premia," CESifo Working Paper Series 8947, CESifo.
    8. M. Hashem Pesaran & Ron P. Smith, 2019. "The Role of Factor Strength and Pricing Errors for Estimation and Inference in Asset Pricing Models," CESifo Working Paper Series 7919, CESifo.

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    More about this item

    Keywords

    Cross-section; Fama–MacBeth; Risk premia; Asset pricing models;
    All these keywords.

    JEL classification:

    • C21 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Cross-Sectional Models; Spatial Models; Treatment Effect Models
    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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