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Optimal Cross-Sectional Regression

Author

Listed:
  • Zhipeng Liao

    (University of California Los Angeles, Los Angeles, California 90095)

  • Yan Liu

    (Tsinghua University, Haidian, Beijing 10084, China)

  • Zhenzhen Xie

    (Tsinghua University, Haidian, Beijing 10084, China)

Abstract

Errors-in-variables (EIV) biases plague asset pricing tests. We offer a new perspective on addressing the EIV issue: instead of viewing EIV biases as estimation errors that potentially contaminate next stage risk premium estimates, we consider them to be return innovations that follow a particular correlation structure. We factor this structure into our test design, yielding a new regression model that generates the most accurate risk premium estimates. We demonstrate the theoretical appeal as well as the empirical relevance of our new estimator.

Suggested Citation

  • Zhipeng Liao & Yan Liu & Zhenzhen Xie, 2024. "Optimal Cross-Sectional Regression," Management Science, INFORMS, vol. 70(11), pages 7911-7942, November.
    • Handle: RePEc:inm:ormnsc:v:70:y:2024:i:11:p:7911-7942
    DOI: 10.1287/mnsc.2023.4966
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