Article1995

The Errors in the Variables Problem in the Cross-Section of Expected Stock Returns

178 citations0/0 files storedThe Journal of Finance

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Financial Markets and Investment Strategies Financial Analysis and Corporate Governance Financial Risk and Volatility Modeling

Abstract

ABSTRACT Recent research has documented the failure of market beta to capture the cross‐section of expected returns within the context of a two‐pass estimation methodology. However, the two‐pass methodology suffers from the errors‐in‐variables (EIV) problem that could attenuate the apparent significance of market beta. This article provides a new correction for the EIV problem that is robust to conditional heteroscedasticity. After the correction, I find more support for the role of market beta and less support for the role of firm size in explaining the cross‐section of expected returns. While the EIV correction leads to a diminished role of firm size, the size variable remains a significant force in explaining the cross‐section of expected returns.

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1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1992The Cross-Section of Expected Stock Returns 1973Risk, Return, and Equilibrium: Empirical Tests 1965The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1981The relationship between return and market value of common stocks 1972Capital Market Equilibrium with Restricted Borrowing 1992

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