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    Factor strengths, pricing errors, and estimation of risk premia

    Smith, Ronald and Pesaran, M. Hashem (2021) Factor strengths, pricing errors, and estimation of risk premia. Working Paper. Munich Society for the Promotion of Economic Research - CESifo, Munich, Germany.

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    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.


    Item Type: Monograph (Working Paper)
    Additional Information: CESifo Working Paper No. 8947. ISSN: 2364-1428
    Keyword(s) / Subject(s): factor strength, pricing errors, risk premia, Fama and MacBeth two-pass estimators, Fama-French factors, panel R squared
    School: School of Business, Economics & Informatics > Economics, Mathematics and Statistics
    Research Centres and Institutes: Applied Macroeconomics, Birkbeck Centre for
    Depositing User: Ron Smith
    Date Deposited: 25 Mar 2022 14:03
    Last Modified: 25 Mar 2022 14:03


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