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Anish S. Menon

Anish S. Menon

Fama Macbeth

1/9

Fama and Macbeth (1973) developed a method by which to test how risk

factors describe portfolio or asset returns. The main goal of the

Fama-Macbeth two step regression is to find the premium from exposure

to these factors.

Anish S. Menon

Fama Macbeth

2/9

more factor time series to determine how exposed it is to each one of

the factor exposures.

In the second step, the cross section of portfolio returns is regressed

against the factor exposures, at each time step, to give a series of risk

premia coefficients for each factor.

The insight of Fama-Macbeth is to then average these coefficients,

once for each factor, to give the premium expected for a unit

exposure to each risk factor over time.

Anish S. Menon

Fama Macbeth

3/9

In equation form, for n portfolio or asset returns and m factors, in the first

step, the factor exposure s are obtained by calculating n regressions, each

one on m factors (each equation in the following represents a regression).

R1,t = 1 + 1,F1 F1,t + 1,F2 F2,t + + 1,Fm Fm,t + 1,t

R2,t = 2 + 2,F1 F1,t + 2,F2 F2,t + + 2,Fm Fm,t + 2,t

..

.

Rn,t = n + n,F1 F1,t + n,F2 F2,t + + n,Fm Fm,t + n,t

(1)

where Ri,t is the return of the portfolio or asset i (n total) at time t, Fj,t

is the factor j (m total) at time t, i,Fm are the factor exposures, or

loadings, that describe how returns are exposed to the factors, and t goes

from time t through T . Notice that each regression uses the same factors

F , because the purpose is to determine the exposure of each portfolios

return to a given set of factors.

Anish S. Menon

Fama Macbeth

4/9

calculated from the first step.

on the m estimates of the s (call them )

Notice that each regression uses the same s from the first step, because

now the goal is the exposure of the n returns to the m factor loadings over

time (e.g., does a larger factor exposure mean a higher return?).

Anish S. Menon

Fama Macbeth

5/9

Ri,1 = 1,0 + 1,1 i,F1 + 1,2 i,F2 + + 1,m i,Fm + i,1

Ri,2 = 2,0 + 2,1 i,F1 + 2,2 i,F2 + + 2,m i,Fm + i,2

..

.

1

(2)

where the returns R are the same as those used in the first stage

regression, are regression coefficients that are used to calculate the risk

premium for each factor, and in each regression i goes, from 1 through n.

Anish S. Menon

Fama Macbeth

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second step), for every factor, each of length T . If the are assumed

to be independently and identically distributed (i.i.d.), calculate the

risk premium m for factor Fm by averaging the mth over T , and

also get standard deviations and t statistics.

T

1 X

t

=

T

i =

Anish S. Menon

1

T

(3)

t=1

T

X

i,t

(4)

t=1

Fama Macbeth

7/9

T

1

1 X

(

) = var (

) = 2

(t )2

T

T

2

(5)

t=1

T

1 X

1

cov (

) = cov (t ) = 2

(

i,t i )(

j,t j )

T

T

(6)

t=1

This methodology ensures that the standard errors are corrected for

cross-sectional correlation. However it does not correct for time series

autocorrelation since it assumes that yearly estimates of the coefficients

are independent over time. A correction as proposed by Peterson(2009) is

to follow a double clustering methodology where there is clustering by

both firm and time.

Anish S. Menon

Fama Macbeth

8/9

t statistic =

m / T

(7)

The Fama Macbeth regression is a rolling regression.

Anish S. Menon

Fama Macbeth

9/9

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