Fama-Macbeth

The beta and expected returns are estimated using the 10 portfolios.
The procedure to set up the 10 red portfolios is exactly the same in both BJS and Fama.

You have a cross-sectional dimension across different portfolios and a time-series dimension
across time.

What did Black Jensen and Scholes do?

• They were able to generate the green line (SML) running a cross-sectional regression
• First, they compute the sample means across time for each portfolio in the cross-section
(the mean of each column), and they regress them over the betas
• The coefficient multiplied by the beta is the market risk premium. So, to get the risk
premium they have run a cross-sectional regression of mean returns over betas.

Fama-Macbeth procedure is essentially the reverse of BJS:

• The idea of Fama is that of taking, line by line, the same regression of retuns over betas
that BJS did, but considering only 1 line at a time (1 month return, not the average)
• In this way you get 30 years * 12 months = 360 estimates of the slope (risk premium), so
you get one estimate per month of the risk premium. BUT these estimates will be very
noisy.
• To remove the noise, as we have seen in the previous lectures, you can take the mean.

FOR THE EXAM YOU MUST KNOW THE DIFFERENCE BETWEEN A CROSS-SECTIONAL AND TIME-
SERIES REGRESSION.

Proposition: If the market is efficient, the Fama-Macbeth procedure, i.e. first running a cross-
sectional regression for monthly returns and then taking the sample mean, works better.
Why?
• The market is efficient when, based on the information available, investors will trade
removing arbitrage opportunities and making prices converge to their fair values.
• If you look at daily stock returns, they are very similar to a sequence of uncorrelated
random variables, so by summing them up you get a martingale (or random walk).
• By definition a martingale is the sum of random variables that are uncorrelated. And, as
we know, the conditional expectation of a martingale is equal to the current value of the
process, so that there is no simple rule to trade on the basis of the information you have.
• So, market efficiency implies a low correlation among stock returns across time (almost
uncorrelated). Instead, stock returns across portfolios (horizontally) have to be
characterized by a strong correlation.
• Thus, the slope (lambda) will be independent across different lines according to what we
stated above. So the 360 lambdas, estimated line by line, are expected to be
uncorrelated because of market efficiency. Then, we can apply the law of large numbers
à by taking the average of the estimates we get the best forecast.

So, we must remember that the lambda (the risk premium) is the outcome of a cross-sectional
regression.

Returns Ri,t observed for different securities and different times define a panel of data. Linear
regressions must take into account the potential biases arising from the cross sectional and the
temporal correlations.
The Fama McBeth two pass approach is the simplest approach trying to account for statistical
issues arising in panel regressions. The strategy is very simple:
• First step à run a time series of cross sectional regressions
• Second step à compute sample means of regression coefficients and sample standard
regressions to measure the significance of the coefficients.