Resolving the Errors-in-Variables Bias in Risk Premium Estimation

69 Pages Posted: 28 Jul 2014 Last revised: 19 Jun 2018

See all articles by Kuntara Pukthuanthong

Kuntara Pukthuanthong

University of Missouri, Columbia

Richard Roll

California Institute of Technology

Junbo L. Wang

Louisiana State University, Baton Rouge

Date Written: July 27, 2014

Abstract

The Fama-Macbeth (1973) rolling-beta method is widely used for estimating risk premiums, but its inherent errors-in-variables bias remains an unresolved problem, particularly when using individual assets or macroeconomic factors. We propose a solution with a particular instrumental variable, beta calculated from alternate observations. The resulting estimators are unbiased. In simulations, we compare this new approach with several existing methods. The new approach corrects the bias even when the sample period is limited. Moreover, our proposed standard errors are unbiased, and lead to correct rejection size in finite samples.

Keywords: error-in-variables, instruments, asset pricing

JEL Classification: G11, G12

Suggested Citation

Pukthuanthong, Kuntara and Roll, Richard W. and Wang, Junbo L., Resolving the Errors-in-Variables Bias in Risk Premium Estimation (July 27, 2014). Available at SSRN: https://ssrn.com/abstract=2472502 or http://dx.doi.org/10.2139/ssrn.2472502

Kuntara Pukthuanthong (Contact Author)

University of Missouri, Columbia ( email )

Robert J. Trulaske, Sr. College of Business
403 Cornell Hall
Columbia, MO 65211
United States
6198076124 (Phone)

HOME PAGE: http://https://kuntara.weebly.com

Richard W. Roll

California Institute of Technology ( email )

1200 East California Blvd
Mail Code: 228-77
Pasadena, CA 91125
United States
626-395-3890 (Phone)
310-836-3532 (Fax)

Junbo L. Wang

Louisiana State University, Baton Rouge ( email )

Baton Rouge, LA 70803
United States

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