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Improved inference in financial factor models


Beck, Elliot; De Nard, Gianluca; Wolf, Michael (2023). Improved inference in financial factor models. Working paper series / Department of Economics 430, University of Zurich.

Abstract

Conditional heteroskedasticity of the error terms is a common occurrence in financial factor models, such as the CAPM and Fama-French factor models. This feature necessitates the use of heteroskedasticity consistent (HC) standard errors to make valid inference for regression coefficients. In this paper, we show that using weighted least squares (WLS) or adaptive least squares (ALS) to estimate model parameters generally leads to smaller HC standard errors compared to ordinary least squares (OLS), which translates into improved inference in the form of shorter confidence intervals and more powerful hypothesis tests. In an extensive empirical analysis based on historical stock returns and commonly used factors, we find that conditional heteroskedasticity is pronounced and that WLS and ALS can dramatically shorten confidence intervals compared to OLS, especially during times of financial turmoil.

Abstract

Conditional heteroskedasticity of the error terms is a common occurrence in financial factor models, such as the CAPM and Fama-French factor models. This feature necessitates the use of heteroskedasticity consistent (HC) standard errors to make valid inference for regression coefficients. In this paper, we show that using weighted least squares (WLS) or adaptive least squares (ALS) to estimate model parameters generally leads to smaller HC standard errors compared to ordinary least squares (OLS), which translates into improved inference in the form of shorter confidence intervals and more powerful hypothesis tests. In an extensive empirical analysis based on historical stock returns and commonly used factors, we find that conditional heteroskedasticity is pronounced and that WLS and ALS can dramatically shorten confidence intervals compared to OLS, especially during times of financial turmoil.

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Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > Department of Economics
Working Paper Series > Department of Economics
Dewey Decimal Classification:330 Economics
JEL Classification:C12, C13, C21
Uncontrolled Keywords:CAPM, conditional heteroskedasticity, factor models, HC standard errors
Scope:Discipline-based scholarship (basic research)
Language:English
Date:March 2023
Deposited On:16 Mar 2023 10:55
Last Modified:06 Mar 2024 14:39
Series Name:Working paper series / Department of Economics
Number of Pages:29
ISSN:1664-7041
OA Status:Green
Related URLs:https://www.zora.uzh.ch/id/eprint/234449/
https://doi.org/10.1016/j.iref.2023.03.009
Other Identification Number:merlin-id:23542
  • Content: Published Version