Title: The role of factor strength and pricing errors for estimation and inference in asset pricing models
Authors: M Hashem Pesaran - USC (United States) [presenting]
Ron Smith - Birkbeck University of London (United Kingdom)
Abstract: The role of factor strength and pricing errors for estimation of risk premia in arbitrage asset pricing models is examined. We introduce a measure of factor strength, distinguish between observed and unobserved factors, and link the unobserved factors to the pricing errors. We show risk premia can be estimated consistently when factors are strong and pricing errors sufficiently weak, irrespective of whether returns on individual securities or portfolios are used. We then derive the distribution of two pass estimator of risk premia, allowing for non-zero pricing errors and provide an empirical application to the three Fama-French factors.