The Errors in the Variables Problem in the Cross-Section of Expected Stock Returns

Dongcheol Kim

Journal of Finance, 1995, vol. 50, issue 5, 1605-34

Abstract: Recent research has documented the failure of market beta to capture the cross-section of expected returns within the context of a two-pass estimation methodology. However, the two-pass methodology suffers from the errors-in-variables (EIV) problem that could attenuate the apparent significance of market beta. This article provides a new correction for the EIV problem that is robust to conditional heteroscedasticity. After the correction, I find more support for the role of market beta and less support for the role of firm size in explaining the cross-section of expected returns. While the EIV correction leads to a diminished role of firm size, the size variable remains a significant force in explaining the cross-section of expected returns. Copyright 1995 by American Finance Association.

Date: 1995
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