Heterogeneous Response: An Extension of the Fama-MacBeth Regression

43 Pages Posted: 23 Mar 2022

See all articles by Xiaoxiao Tang

Xiaoxiao Tang

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

Xiwei Tang

University of Virginia

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School

Date Written: January 17, 2022

Abstract

We propose an extension of the Fama-MacBeth regression by allowing stock returns to respond differently to firm characteristics. This heterogeneous model can potentially capture non-linearity and interactions. Empirical, applying it to a common set of fifteen firm characteristics, we find that the value-weighted long-short portfolio has an annualized Sharpe ratio of 0.97, doubling that of the usual homogenous model, and our model is not only easier to understand, but also performs better than existing machine learning models. We also propose a test detecting which risk exhibits heterogeneous reactions, and find that heterogeneity is significant for firm size, momentum, and stock volatility. Furthermore, we find that heterogeneous reactions are more pronounced during recession periods.

Keywords: Fama-MacBeth approach, cross-section of stock returns, long-short portfolio, out-of-sample prediction

JEL Classification: C53, C55, C58, G11, G12, G17

Suggested Citation

Tang, Xiaoxiao and Tang, Xiwei and Zhou, Guofu, Heterogeneous Response: An Extension of the Fama-MacBeth Regression (January 17, 2022). Available at SSRN: https://ssrn.com/abstract=4011460 or http://dx.doi.org/10.2139/ssrn.4011460

Xiaoxiao Tang

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

2601 North Floyd Road
P.O. Box 830688
Richardson, TX 75083
United States

Xiwei Tang

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

Guofu Zhou (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

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