Publication Date
Financial Markets Group Discussion Papers DP 975
Commonly used frequentist estimation methods for linear factor models of asset returns are invalidated by weak and spurious factors. The problem is amplified by omitted variables and model misspecification, often calling for specialized non-standard estimation techniques. Conversely, the Bayesian analogue of the popular Fama and MacBeth (1973) two-pass regressions method provides reliable risk premia estimates for both tradable and nontradable factors, detects those weakly identified, delivers valid credible intervals for all objects of interest, and is intuitive, fast and simple to implement. In other words, weak and spurious factors are not a problem for the Bayesian estimation of Fama-MacBeth regressions.
