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Factor Strengths, Pricing Errors, and Estimation of Risk Premia

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  • M. Hashem Pesaran
  • Ron P. Smith

Abstract

This paper examines the implications of pricing errors and factors that are not strong for the Fama-MacBeth two-pass estimator of risk premia and its asymptotic distribution when T is fixed with n → ∞, and when both n and T → ∞, jointly. While the literature just distinguishes strong and weak factors we allow for degrees of strength using a recently developed measure. Our theoretical results have important practical implications for empirical asset pricing. Pricing errors and factor strength matter for consistent estimation of risk premia and subsequent inference, thus an estimate of factor strength is required before attempting to estimate risk. Finally, using a recently developed procedure we provide rolling estimates of factor strengths for the five Fama-French factors, and show that only the market factor can be viewed as strong.

Suggested Citation

  • M. Hashem Pesaran & Ron P. Smith, 2021. "Factor Strengths, Pricing Errors, and Estimation of Risk Premia," CESifo Working Paper Series 8947, CESifo.
    • Handle: RePEc:ces:ceswps:_8947
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    References listed on IDEAS

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    Cited by:

    1. Natalia Bailey & George Kapetanios & M. Hashem Pesaran, 2021. "Measurement of factor strength: Theory and practice," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 36(5), pages 587-613, August.
    2. 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.
    3. 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.
    4. Feng, Long & Lan, Wei & Liu, Binghui & Ma, Yanyuan, 2022. "High-dimensional test for alpha in linear factor pricing models with sparse alternatives," Journal of Econometrics, Elsevier, vol. 229(1), pages 152-175.

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    More about this item

    Keywords

    factor strength; pricing errors; risk premia; Fama and MacBeth two-pass estimators; Fama-French factors; panel R2;
    All these keywords.

    JEL classification:

    • C38 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Classification Methdos; Cluster Analysis; Principal Components; Factor Analysis
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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