GMM Weighting Matrices in Cross-Sectional Asset Pricing Tests

58 Pages Posted: 21 Nov 2017 Last revised: 27 Jan 2021

See all articles by Nora Laurinaityte

Nora Laurinaityte

Bank of Lithuania

Christoph Meinerding

Deutsche Bundesbank

Christian Schlag

Goethe University Frankfurt; Leibniz Institute for Financial Research SAFE

Julian Thimme

Karlsruhe Institute of Technology

Date Written: January 26, 2021

Abstract

Cross-sectional asset pricing tests with GMM can generate spuriously high explanatory power for factor models when the moment conditions are specified such that they allow the estimated factor means to substantially deviate from the observed sample averages. In fact, by shifting the weights on the moment conditions, any level of cross-sectional fit can be attained. This property is a feature of the GMM estimation design and applies to strong as well as weak factors, and to all sample sizes and test assets. We reveal the origins of this bias theoretically, gauge its size using simulations, and document its relevance empirically.

Keywords: Asset pricing, cross-section of expected returns, GMM, factor zoo

JEL Classification: G00, G12, C21, C13

Suggested Citation

Laurinaityte, Nora and Meinerding, Christoph and Schlag, Christian and Thimme, Julian, GMM Weighting Matrices in Cross-Sectional Asset Pricing Tests (January 26, 2021). Available at SSRN: https://ssrn.com/abstract=3073197 or http://dx.doi.org/10.2139/ssrn.3073197

Nora Laurinaityte

Bank of Lithuania ( email )

Totoriu 4
Vilnius, LT-01121
Lithuania

Christoph Meinerding (Contact Author)

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

Christian Schlag

Goethe University Frankfurt ( email )

Faculty of Economics and Business
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, Hessen 60323
Germany

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany
+49 69 798 33699 (Phone)

Julian Thimme

Karlsruhe Institute of Technology ( email )

Kaiserstra├če 12
Karlsruhe, Baden W├╝rttemberg 76131
Germany

HOME PAGE: http://julianthimme.de

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