How Fama-MacBeth Can Go Wrong – And an Informative Solution

56 Pages Posted: 15 Mar 2011

See all articles by Lynda Khalaf

Lynda Khalaf

Carleton University

Huntley Schaller

Carleton University - Department of Economics

Date Written: March 14, 2011

Abstract

We find that weak identification can lead to econometric problems with Fama-MacBeth regressions, including serious size distortions and biased point estimates. Two sources of weak identification are particularly important and have been little studied in the finance literature – small betas and collinearity in the beta matrix. We introduce a technique (RTP) to deal with weak identification and compare the new technique with Fama-MacBeth and other alternatives. RTP has correct size and very good power to reject misspecified models. RTP has two further useful properties: 1) it provides a warning of weak identification; 2) model rejections can be informative.

Keywords: asset pricing models, asset pricing tests, weak identification, useless factors, small betas, CAPM, Carhart model, Fama-French three-factor model, Lettau-Ludvigson model

JEL Classification: G12, C12, C13

Suggested Citation

Khalaf, Lynda and Schaller, Huntley, How Fama-MacBeth Can Go Wrong – And an Informative Solution (March 14, 2011). Available at SSRN: https://ssrn.com/abstract=1785858 or http://dx.doi.org/10.2139/ssrn.1785858

Lynda Khalaf (Contact Author)

Carleton University ( email )

1125 colonel By Drive
Ottawa, Ontario K1S 5B6
Canada

Huntley Schaller

Carleton University - Department of Economics ( email )

1125 Colonel By Drive
Ottawa, Ontario K1S 5B6
Canada
613-520-3751 (Phone)
613-520-3906 (Fax)

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