A Synthesis of Two Factor Estimation Methods
42 Pages Posted: 21 Aug 2009 Last revised: 14 Nov 2015
Date Written: August 6, 2015
Two-pass cross sectional regression (TPCSR) is frequently used in estimating factor risk premiums. Recent papers argue that the common practice of grouping assets into portfolios to reduce the errors-in-variables (EIV) problem leads to loss of efficiency and masks potential deviations from asset pricing models. One solution that allows the use of individual assets while overcoming the EIV problem is iterated TPCSR (ITPCSR). ITSCSR converges to a fixed point regardless of the initial factors chosen. ITPCSR is intimately linked to the asymptotic principal components (APC) method of estimating factors since the ITPCSR estimates are the APC estimates, up to a rotation.
Keywords: Cross-sectional regression, Factor model, Principal components, Errors in variables
JEL Classification: G1, G12, C3
Suggested Citation: Suggested Citation