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Lecture Notes in Financial Econometrics

Lecture Notes in Financial Econometrics

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Reference: Cochrane (2001) 12.3; Campbell, Lo, and MacKinlay (1997) 5.8; Fama and

MacBeth (1973)

The Fama and MacBeth (1973) approach is a bit different from the regression ap-

proaches discussed so far. The method has three steps, described below.

First, estimate the betas ˇi (i D 1;:::;n) from (4.2) (this is a time-series regres-
sion). This is often done on the whole sample—assuming the betas are constant.

Sometimes, the betas are estimated separately for different sub samples (so we

could let Oˇi carry a time subscript in the equations below).

Second, run a cross sectional regression for every t. That is, for period t, estimate
t from the cross section (across the assets i D 1;:::;n) regression

Re

it D 0
t

Oˇi C"it;

(4.19)

90

4

6

8

10

12

14

16

18

4

6

8

10

12

14

16

18

Predicted mean excess return (FF), %

M

ean excess return, %

lines connect same size

1 (small)

2

3

4

5 (large)

Figure 4.9: FF, FF portfolios

where Oˇi are the regressors. (Note the difference to the traditional cross-sectional

approach discussed in (4.9), where the second stage regression regressed ERe

it on

Oˇi, while the Fama-French approach runs one regression for every time period.)

Third, estimate the time averages

O"i D 1
T

T
XtD1

O"it for i D 1;:::;n, (for every asset)

(4.20)

O D 1
T

T
XtD1

O t:

(4.21)

The second step, using Oˇi as regressors, creates an errors-in-variables problem since
Oˇi are estimated, that is, measured with an error. The effect of this is typically to bias the
estimatorof t towardszero(andanyintercept, ormeanoftheresidual, isbiasedupward).

One way to minimize this problem, used by Fama and MacBeth (1973), is to let the assets

be portfolios of assets, for which we can expect some of the individual noise in the first-

91

4

6

8

10

12

14

16

18

4

6

8

10

12

14

16

18

Predicted mean excess return (FF), %

M

ean excess return, %

lines connect same B/M

1 (low)

2

3

4

5 (high)

Figure 4.10: FF, FF portfolios

step regressions to average out—and thereby make the measurement error in Oˇi smaller.

If CAPM is true, then the return of an asset is a linear function of the market return and an

error which should be uncorrelated with the errors of other assets—otherwise some factor

is missing. If the portfolio consists of 20 assets with equal error variance in a CAPM

regression, then we should expect the portfolio to have an error variance which is 1/20th

as large.

We clearly want portfolios which have different betas, or else the second step regres-

sion (4.19) does not work. Fama and MacBeth (1973) choose to construct portfolios

according to some initial estimate of asset specific betas. Another way to deal with the

errors-in-variables problem is to adjust the tests.

We can test the model by studying if "i D 0 (recall from (4.20) that "i is the time

average of the residual for asseti,"it), by forming a t-test O"i=Std.O"i/. Fama and MacBeth

(1973) suggest that the standard deviation should be found by studying the time-variation

in O"it. In particular, they suggest that the variance of O"it (not O"i) can be estimated by the

92

(average) squared variation around its mean

Var.O"it/ D 1
T

T
XtD1

.O"it O"i/2

:

(4.22)

Since O"i is the sample average of O"it, the variance of the former is the variance of the latter

divided by T (the sample size)—provided O"it is iid. That is,

Var.O"i/ D 1
T

Var.O"it/ D 1
T2

T
XtD1

.O"it O"i/2

:

(4.23)

A similar argument leads to the variance of O

Var.O / D 1
T2

T
XtD1

.O t O /2
:

(4.24)

Fama and MacBeth (1973) found, among other things, that the squared beta is not

significant in the second step regression, nor is a measure of non-systematic risk.

A Statistical Tables

n

Critical values
10% 5% 1%

10

1.81 2.23 3.17

20

1.72 2.09 2.85

30

1.70 2.04 2.75

40

1.68 2.02 2.70

50

1.68 2.01 2.68

60

1.67 2.00 2.66

70

1.67 1.99 2.65

80

1.66 1.99 2.64

90

1.66 1.99 2.63
100 1.66 1.98 2.63
Normal 1.64 1.96 2.58

Table A.1: Critical values (two-sided test) of t distribution (different degrees of freedom)
and normal distribution.

93

n Critical values
10% 5% 1%
1 2.71 3.84 6.63
2 4.61 5.99 9.21
3 6.25 7.81 11.34
4 7.78 9.49 13.28
5 9.24 11.07 15.09
6 10.64 12.59 16.81
7 12.02 14.07 18.48
8 13.36 15.51 20.09
9 14.68 16.92 21.67
10 15.99 18.31 23.21

Table A.2: Critical values of chisquare distribution (different degrees of freedom, n).

Bibliography

Campbell, J. Y., A. W. Lo, and A. C. MacKinlay, 1997, The econometrics of financial

markets, Princeton University Press, Princeton, New Jersey.

Chen, N.-F., R. Roll, and S. A. Ross, 1986, “Economic forces and the stock market,”

Journal of Business, 59, 383–403.

Cochrane, J. H., 2001, Asset pricing, Princeton University Press, Princeton, New Jersey.

Elton, E. J., M. J. Gruber, S. J. Brown, and W. N. Goetzmann, 2010, Modern portfolio

theory and investment analysis, John Wiley and Sons, 8th edn.

Fama, E., and J. MacBeth, 1973, “Risk, return, and equilibrium: empirical tests,” Journal

of Political Economy, 71, 607–636.

Fama, E. F., and K. R. French, 1993, “Common risk factors in the returns on stocks and

bonds,” Journal of Financial Economics, 33, 3–56.

Fama, E. F., and K. R. French, 1996, “Multifactor explanations of asset pricing anoma-

lies,” Journal of Finance, 51, 55–84.

Gibbons, M., S. Ross, and J. Shanken, 1989, “A test of the efficiency of a given portfolio,”

Econometrica, 57, 1121–1152.

94

MacKinlay, C., 1995, “Multifactor models do not explain deviations from the CAPM,”

Journal of Financial Economics, 38, 3–28.

Wooldridge, J. M., 2002, Econometric analysis of cross section and panel data, MIT

Press.

95

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