IDEAS home Printed from https://ideas.repec.org/a/wsi/rpbfmp/v22y2019i02ns0219091519500127.html
   My bibliography  Save this article

The Bias in Two-Pass Regression Tests of Asset-Pricing Models in Presence of Idiosyncratic Errors with Cross-Sectional Dependence

Author

Listed:
  • Thomas Gramespacher

    (Department of Banking, Finance, Insurance, Zurich University of Applied Sciences, Technoparkstrasse 2, P. O. Box, 8401 Winterthur, Switzerland)

  • Armin Bänziger

    (Department of Banking, Finance, Insurance, Zurich University of Applied Sciences, Technoparkstrasse 2, P. O. Box, 8401 Winterthur, Switzerland)

Abstract

In two-pass regression-tests of asset-pricing models, cross-sectional correlations in the errors of the first-pass time-series regression lead to correlated measurement errors in the betas used as explanatory variables in the second-pass cross-sectional regression. The slope estimator of the second-pass regression is an estimate for the factor risk-premium and its significance is decisive for the validity of the pricing model. While it is well known that the slope estimator is downward biased in presence of uncorrelated measurement errors, we show in this paper that the correlations seen in empirical return data substantially suppress this bias. For the case of a single-factor model, we calculate the bias of the OLS slope estimator in the presence of correlated measurement errors with a first-order Taylor-approximation in the size of the errors. We show that the bias increases with the size of the errors, but decreases the more the errors are correlated. We illustrate and validate our result using a simulation approach based on empirical data commonly used in asset-pricing tests.

Suggested Citation

  • Thomas Gramespacher & Armin Bänziger, 2019. "The Bias in Two-Pass Regression Tests of Asset-Pricing Models in Presence of Idiosyncratic Errors with Cross-Sectional Dependence," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 22(02), pages 1-17, June.
    • Handle: RePEc:wsi:rpbfmp:v:22:y:2019:i:02:n:s0219091519500127
    DOI: 10.1142/S0219091519500127
    as

    Download full text from publisher

    File URL: http://www.worldscientific.com/doi/abs/10.1142/S0219091519500127
    Download Restriction: Access to full text is restricted to subscribers
    File URL: https://libkey.io/10.1142/S0219091519500127?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Michael C. Jensen, 1968. "The Performance Of Mutual Funds In The Period 1945–1964," Journal of Finance, American Finance Association, vol. 23(2), pages 389-416, May.
    2. Pollet, Joshua M. & Wilson, Mungo, 2010. "Average correlation and stock market returns," Journal of Financial Economics, Elsevier, vol. 96(3), pages 364-380, June.
    3. 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.
    4. Tobias Schlueter & Soenke Sievers, 2014. "Determinants of market beta: the impacts of firm-specific accounting figures and market conditions," Review of Quantitative Finance and Accounting, Springer, vol. 42(3), pages 535-570, April.
    5. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," The Review of Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
    6. Kim, Soohun & Skoulakis, Georgios, 2018. "Ex-post risk premia estimation and asset pricing tests using large cross sections: The regression-calibration approach," Journal of Econometrics, Elsevier, vol. 204(2), pages 159-188.
    7. Robert J. Bianchi & Michael E. Drew & Timothy Whittaker, 2016. "The Predictive Performance of Asset Pricing Models: Evidence from the Australian Securities Exchange," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 19(04), pages 1-18, December.
    8. Litzenberger, Robert H. & Ramaswamy, Krishna, 1979. "The effect of personal taxes and dividends on capital asset prices : Theory and empirical evidence," Journal of Financial Economics, Elsevier, vol. 7(2), pages 163-195, June.
    9. Fama, Eugene F. & French, Kenneth R., 2015. "A five-factor asset pricing model," Journal of Financial Economics, Elsevier, vol. 116(1), pages 1-22.
    10. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    11. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-636, May-June.
    12. Eugene F. Fama & Kenneth R. French, 2004. "The Capital Asset Pricing Model: Theory and Evidence," Journal of Economic Perspectives, American Economic Association, vol. 18(3), pages 25-46, Summer.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. M Hashem Pesaran & Takashi Yamagata, 2024. "Testing for Alpha in Linear Factor Pricing Models with a Large Number of Securities," Journal of Financial Econometrics, Oxford University Press, vol. 22(2), pages 407-460.
    2. Kim, Soohun & Skoulakis, Georgios, 2018. "Ex-post risk premia estimation and asset pricing tests using large cross sections: The regression-calibration approach," Journal of Econometrics, Elsevier, vol. 204(2), pages 159-188.
    3. Simmet Anastasia & Pohlmeier Winfried, 2020. "The CAPM with Measurement Error: ‘There’s life in the old dog yet!’," Journal of Economics and Statistics (Jahrbuecher fuer Nationaloekonomie und Statistik), De Gruyter, vol. 240(4), pages 417-453, August.
    4. Patrick Gagliardini & Elisa Ossola & Olivier Scaillet, 2016. "Time‐Varying Risk Premium in Large Cross‐Sectional Equity Data Sets," Econometrica, Econometric Society, vol. 84, pages 985-1046, May.
    5. Amit Goyal, 2012. "Empirical cross-sectional asset pricing: a survey," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(1), pages 3-38, March.
    6. Gagliardini, Patrick & Ossola, Elisa & Scaillet, Olivier, 2019. "Estimation of large dimensional conditional factor models in finance," Working Papers unige:125031, University of Geneva, Geneva School of Economics and Management.
    7. Fernando Rubio, 2005. "Eficiencia De Mercado, Administracion De Carteras De Fondos Y Behavioural Finance," Finance 0503028, University Library of Munich, Germany, revised 23 Jul 2005.
    8. Racicot, François-Éric & Rentz, William F., 2018. "Does Illiquidity Matter? An Errors-in-Variables Perspective/¿Es importante la iliquidez? Un análisis desde el enfoque de errores en variables," Estudios de Economia Aplicada, Estudios de Economia Aplicada, vol. 36, pages 251-262, Enero.
    9. Bathia, Deven & Bredin, Don, 2018. "Investor sentiment: Does it augment the performance of asset pricing models?," International Review of Financial Analysis, Elsevier, vol. 59(C), pages 290-303.
    10. Kwon, Ji Ho, 2024. "Bank credit, consumption risk, and the cross-section of expected returns," International Review of Financial Analysis, Elsevier, vol. 92(C).
    11. Stotz, Olaf, 2018. "A labor news hedge portfolio and the cross-section of expected stock returns," Journal of Empirical Finance, Elsevier, vol. 48(C), pages 123-139.
    12. repec:gnv:wpaper:unige:76321 is not listed on IDEAS
    13. Fletcher, Jonathan, 2018. "Betas V characteristics: Do stock characteristics enhance the investment opportunity set in U.K. stock returns?," The North American Journal of Economics and Finance, Elsevier, vol. 46(C), pages 114-129.
    14. Cakici, Nusret & Zaremba, Adam, 2021. "Who should be afraid of infections? Pandemic exposure and the cross-section of stock returns," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 72(C).
    15. Zhang, Han, 2021. "An inflation-based ICAPM in China," Pacific-Basin Finance Journal, Elsevier, vol. 68(C).
    16. Kolari, James W. & Huang, Jianhua Z. & Butt, Hilal Anwar & Liao, Huiling, 2022. "International tests of the ZCAPM asset pricing model," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 79(C).
    17. Bakalli, Gaetan & Guerrier, Stéphane & Scaillet, Olivier, 2023. "A penalized two-pass regression to predict stock returns with time-varying risk premia," Journal of Econometrics, Elsevier, vol. 237(2).
    18. Qi Shi & Bin Li & Adrian (Wai Kong) Cheung & Richard Chung, 2017. "Augmenting the intertemporal CAPM with inflation: Further evidence from alternative models," Australian Journal of Management, Australian School of Business, vol. 42(4), pages 653-672, November.
    19. Attiya Yasmeen Javid, 2000. "Alternative Capital Asset Pricing Models: A Review of Theory and Evidence," PIDE Research Report 2000:3, Pakistan Institute of Development Economics.
    20. Kim, Jinyong & Kim, Kun Ho & Lee, Jeong Hwan, 2021. "Cross-sectional tests of asset pricing models with full-rank mimicking portfolios," The North American Journal of Economics and Finance, Elsevier, vol. 57(C).
    21. Shafiqur Rahman & Matthew J. Schneider, 2019. "Tests of Alternative Asset Pricing Models Using Individual Security Returns and a New Multivariate F-Test," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 22(01), pages 1-34, March.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:wsi:rpbfmp:v:22:y:2019:i:02:n:s0219091519500127. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Tai Tone Lim (email available below). General contact details of provider: http://www.worldscinet.com/rpbfmp/rpbfmp.shtml .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.