Factor models with many assets: Strong factors, weak factors, and the two-pass procedure

Stanislav Anatolyev and Anna Mikusheva

Journal of Econometrics, 2022, vol. 229, issue 1, 103-126

Abstract: This paper re-examines the problem of estimating risk premia in unconditional linear factor pricing models. Typically, the data used in the empirical literature are characterized by weakness of some pricing factors, strong cross-sectional dependence in the errors, and (moderately) high cross-sectional dimensionality. Using an asymptotic framework where the number of assets/portfolios grows with the time span of the data while the risk exposures of weak factors are local-to-zero, we show that the conventional two-pass estimation procedure delivers inconsistent estimates of the risk premia. We propose a new estimation procedure based on sample-splitting instrumental variables regression. The proposed estimator of risk premia is robust to weak included factors and to the presence of strong unaccounted cross-sectional error dependence. We prove the consistency of the new estimator, establish asymptotically valid inferences using Wald statistics, verify performance of the new procedure in simulations, and revisit some empirical studies.

Keywords: Factor models; Risk premium; Two-pass procedure; Strong and weak factors; Dimension asymptotics (search for similar items in EconPapers)
JEL-codes: C33 C38 C58 G12 (search for similar items in EconPapers)
Date: 2022
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

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Working Paper: Factor models with many assets: strong factors, weak factors, and the two-pass procedure (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:econom:v:229:y:2022:i:1:p:103-126

DOI: 10.1016/j.jeconom.2021.01.002

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