Correlation and the Omitted Variable: A Tale of Two Prices

Financial Management Accepted

50 Pages Posted: 15 Jan 2019 Last revised: 25 Aug 2020

See all articles by Xing Han

Xing Han

University of Auckland Business School; Ghent University - Department of Financial Economics

Zheyao Pan

Macquarie University

Date Written: August 20, 2020

Abstract

We offer a new perspective on the low-beta anomaly by acknowledging the omitted-variable problem in the correlation component of beta: Correlation is “plagued” by firm size (the omitted variable) to exhibit a negative price. Once isolating the size impact, a hidden positive price emerges for the size-orthogonalized component of correlation. Further analyses suggest that i). The positive price of the size-orthogonalized component is not due to mispricing, supporting the return comovement-based pricing channel. ii). The negative price of the size-explained component is related to illiquidity and coskewness. iii). The omitted-variable problem also applies to the pricing of beta.

Keywords: Correlation, Beta Anomaly, Omitted Variable Bias

JEL Classification: G11, G12, G14

Suggested Citation

Han, Xing and Pan, Zheyao, Correlation and the Omitted Variable: A Tale of Two Prices (August 20, 2020). Financial Management Accepted, Available at SSRN: https://ssrn.com/abstract=3315919

Xing Han

University of Auckland Business School ( email )

12 Grafton Rd
Private Bag 92019
Auckland, 1010
New Zealand

Ghent University - Department of Financial Economics ( email )

Sint-Pietersplein 5
Ghent, 9000
Belgium

Zheyao Pan (Contact Author)

Macquarie University ( email )

North Ryde
Sydney, New South Wales 2109
Australia

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