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Cross-Sectional Estimation Biases in Risk Premia and Zero-Beta Excess Returns

38 Pages Posted: 29 Dec 2008 Last revised: 20 Jul 2009

Jianhua Yuan

George Washington University - Department of Finance; Federal National Mortgage Association (Fannie Mae)

Robert Savickas

George Washington University - School of Business - Department of Finance

Date Written: July 7, 2009

Abstract

This paper shows that the classic cross-sectional asset pricing tests tend to suffer from severe risk-premium estimation errors because of small variation in betas. We explain how the conventional approach uses low criteria to validate an asset-pricing model and suffers from the model-misspecification issue because of the complication associated with the zero-beta excess return. We show that the resulting biases in estimates of risk premia and their standard errors are severe enough to lead researchers into inferring incorrect implications about some asset-pricing theories being tested. Further, we suggest that one simple method of mitigating these issues is to restrict the zero-beta excess returns to their theoretical values in the crosssectional regressions and to conduct the straightforward test of whether the estimated ex-ante risk premia are consistent with the observed ex-post ones. The empirical testing results not only further affirm the higher efficiency of the estimates produces by the suggested method, but also show, contrary to some prior evidence, that the market factor is priced consistently.

Keywords: Cross-Sectional Regression, Consistent Estimator, Efficient Estimator, Risk Premium, Zero-Beta Return, Model Misspecification, Beta-Variation

JEL Classification: G12, C13, C12

Suggested Citation

Yuan, Jianhua and Savickas, Robert, Cross-Sectional Estimation Biases in Risk Premia and Zero-Beta Excess Returns (July 7, 2009). Available at SSRN: https://ssrn.com/abstract=1314594 or http://dx.doi.org/10.2139/ssrn.1314594

Jianhua Yuan (Contact Author)

George Washington University - Department of Finance ( email )

2023 G Street
Washington, DC 20052
United States

Federal National Mortgage Association (Fannie Mae) ( email )

3900 Wisconsin Avenue, NW
Washington, DC 20016-2892
United States
(202) 752-1699 (Phone)

Robert Savickas

George Washington University - School of Business - Department of Finance ( email )

Funger Hall, Suite 501R
2201 G Street, N.W.
Washington, DC 20052
United States
202-994-8936 (Phone)
202-994-5014 (Fax)

HOME PAGE: http://savickas.net/

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