Resolving the Errors-in-Variables Bias in Risk Premium Estimation
69 Pages Posted: 28 Jul 2014 Last revised: 19 Jun 2018
Date Written: July 27, 2014
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: Suggested Citation