Working Papers

• The Role of Pricing Errors in Linear Asset Pricing Models with Strong, Semi-strong, and Latent Factors, by M. Hashem Pesaran and Ron P. Smith, February 2023, Cambridge Working Papers in Economics, CWPE2317, CESifo Working Paper No. 10282
• Causal Effects of the Fed's Large-Scale Asset Purchases on Firms' Capital Structure, by Andrea Nocera and M. Hashem Pesaran, April 2022, Cambridge Working Papers in Economics, CWPE2224
• Forecasting with Panel Data: Estimation Uncertainty Versus Parameter Heterogeneity, by M. Hashem Pesaran, Andreas Pick and Allan Timmermann, March 2022, Cambridge Working Papers in Economics, CWPE2219
• Revisiting the Great Ratios Hypothesis, by Alexander Chudik, M. Hashem Pesaran and Ron P. Smith, March 2022, Cambridge Working Papers in Economics, CWPE2215 and CESifo Working Paper No. 9625
• A Bias-Corrected CD Test for Error Cross-Sectional Dependence in Panel Data Models with Latent Factors, by M. Hashem Pesaran and Yimeng Xie, July 2021, revised August 2022, Cambridge Working Papers in Economics, CWPE2158 and and CESifo Working Paper No. 9234
• Pooled Bewley Estimator of Long Run Relationships in Dynamic Heterogenous Panels, by Alexander Chudik, M. Hashem Pesaran, and Ron P. Smith, May 2021
• Variable Selection in High Dimensional Linear Regressions with Parameter Instability, by Alexander Chudik, M. Hashem Pesaran and Mahrad Sharifvaghe, July 2020, revised January 2023
• The Role of Factor Strength and Pricing Errors for Estimation and Inference in Asset Pricing Models, by M. Hashem Pesaran and Ron P. Smith, CESifo Working Paper No. tbc, October 2019
• Business Cycle Effects of Credit Shocks in a DSGE Model with Firm Defaults, by M. Hashem Pesaran and TengTeng Xu, CWPE Working paper. No. 1159, CESifo Working Paper No. 3609, IZA Discussion Paper No. 6027, October 2011, revised April 2016
• Optimality and Diversifiability of Mean Variance and Arbitrage Pricing Portfolios, by M. Hashem Pesaran and Paolo Zaffaroni,, CESifo Working Papers No. 2857, October, 2009

Archives: WP version of published papers

• "The Role of Pricing Errors in Linear Asset Pricing Models with Strong, Semi-strong, and Latent Factors", by M. Hashem Pesaran and Ron P. Smith, February 2023, Cambridge Working Papers in Economics, CWPE2317, CESifo Working Paper No. 10282

  Abstract: This paper examines the role of pricing errors in linear factor pricing models, allowing for observed strong and semi-strong factors, and latent weak factors. It focusses on the estimation of Φ_k = λ_k - μ_k which plays a pivotal role, not only in the estimation of risk premia but also in tests of market efficiency, where λ_k and μ_k are respectively the risk premium and the mean of the k^th risk factor. It proposes a two-step estimator of Φ_k with Shanken type bias-correction, and derives its asymptotic distribution under a general setting that allows for idiosyncratic pricing errors, weak missing factors, as well as weak error cross-sectional dependence. The implications of semi-strong factors for the asymptotic distribution of the proposed estimator are also investigated. Small sample results from extensive Monte Carlo experiments show that the proposed estimator has the correct size with good power properties. The paper also provides an empirical application to a large number of U.S. securities with risk factors selected from a large number of potential risk factors according to their strength.
  JEL Classifications: C38, G10
  Key Words: Factor strength, pricing errors, risk premia, missing factors, Fama-French factors, panel R²
  Full Text: https://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe2317.pdf
  CESifo Link: https://www.cesifo.org/en/publications/2023/working-paper/role-pricing-errors-linear-asset-pricing-models-strong-semi-strong

   

• "Causal Effects of the Fed's Large-Scale Asset Purchases on Firms' Capital Structure, by Andrea Nocera and M. Hashem Pesaran, April 2022, Cambridge Working Papers in Economics, CWPE2224

  Abstract: This paper investigates the short- and long-term impacts of the Federal Reserve’s large-scale asset purchases (LSAPs) on the capital structure of U.S. non-financial firms. To isolate the effects of LSAPs from the impact of concurrent macroeconomic conditions, we exploit cross-industry variations in the ability of firms therein to raise external funds without exhausting their debt capacity. We show that firms’ responses to LSAPs strongly depend on the financing decisions of other peers in the same industry. The higher the proportion of firms without high debt burdens in an industry, the stronger the response of firms within the industry to the Fed’s asset purchases. Overall, our results show that LSAPs facilitated firms’ access to debt financing and that the impacts of LSAPs on firms’ capital structure are likely to be long-lasting.
  JEL Classifications: G32, E44, E52, E58
  Key Words: Capital structure, identification, interactive effects, leverage, quantitative easing, unconventional monetary policy
  Full Text: https://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe2224.pdf

   

• "Forecasting with Panel Data: Estimation Uncertainty Versus Parameter Heterogeneity", by M. Hashem Pesaran, Andreas Pick and Allan Timmermann, March 2022, Cambridge Working Papers in Economics, CWPE2219

  Abstract: We develop novel forecasting methods for panel data with heterogeneous parameters and examine them together with existing approaches. We conduct a systematic comparison of their predictive accuracy in settings with different cross-sectional (N) and time (T) dimensions and varying degrees of parameter heterogeneity. We investigate conditions under which panel forecasting methods can perform better than forecasts based on individual estimates and demonstrate how gains in predictive accuracy depend on the degree of parameter heterogeneity, whether heterogeneity is correlated with the regressors, the goodness of fit of the model, and, particularly, the time dimension of the data set. We propose optimal combination weights for forecasts based on pooled and individual estimates and develop a novel forecast poolability test that can be used as a pretesting tool. Through a set of Monte Carlo simulations and three empirical applications to house prices, CPI inflation, and stock returns, we show that no single forecasting approach dominates uniformly. However, forecast combination and shrinkage methods provide better overall forecasting performance and offer more attractive risk profiles compared to individual, pooled, and random effects methods.
  JEL Classifications: C33, C53
  Key Words: Forecasting, Panel data, Heterogeneity, Forecast evaluation, Forecast combination, Shrinkage, Pooling
  Full Text: https://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe2219.pdf

   

• "Revisiting the Great Ratios Hypothesis", by Alexander Chudik, M. Hashem Pesaran and Ron P. Smith, March 2022, Cambridge Working Papers in Economics, CWPE2215 and CESifo Working Paper No. 9625

  Abstract: The idea that certain economic variables are roughly constant in the long-run is an old one. Kaldor described them as stylized facts, whereas Klein and Kosobud labelled them great ratios. While such ratios are widely adopted in theoretical models in economics as conditions for balanced growth, arbitrage or solvency, the empirical literature has tended to find little evidence for them. We argue that this outcome could be due to episodic failure of cointegration, possible two-way causality between the variables in the ratios, and cross-country error dependence due to latent factors. We propose a new system pooled mean group estimator (SPMG) to deal with these features. Using this new panel estimator and a dataset spanning almost one and half centuries and seventeen countries, we find support for five out of the seven great ratios that we consider. Extensive Monte Carlo experiments also show that the SPMG estimator with bootstrapped confidence intervals stands out as the only estimator with satisfactory small sample properties.
  JEL Classifications: B40, C18, C33, C50
  Key Words: Great ratios, debt, consumption, and investment to GDP ratios, arbitrage conditions, heterogeneous panels, episodic cointegration, two-way long-run causality, error cross-sectional dependence
  Full Text: https://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe2215.pdf
  CESifo: https://www.cesifo.org/en/publikationen/2022/working-paper/revisiting-great-ratios-hypothesis

   

• "A Bias-Corrected CD Test for Error Cross-Sectional Dependence in Panel Data Models with Latent Factors", by M. Hashem Pesaran and Yimeng Xie, July 2021, revised August 2022, Cambridge Working Papers in Economics, CWPE2158 and and CESifo Working Paper No. 9234.

  Abstract: In a recent paper Juodis and Reese (2022) (JR) show that the application of the CD test proposed by Pesaran (2004) to residuals from panels with latent factors results in over-rejection. They propose a randomized test statistic to correct for over-rejection, and add a screening component to achieve power. This paper considers the same problem but from a different perspective. It shows that the standard CD test remains valid if the latent factors are weak, and proposes a simple bias-corrected CD test, labelled CD*, which is shown to be asymptotically normal, irrespective of whether the latent factors are weak or strong. This result is shown to hold for pure latent factor models as well as for panel regressions with latent factors. The case where the errors are serially correlated is also considered. Small sample properties of the CD* test are investigated by Monte Carlo experiments and are shown to have the correct size and satisfactory power for both Gaussian and non-Gaussian errors. In contrast, it is found that JR's test tends to over-reject in the case of panels with non-Gaussian errors, and has low power against spatial network alternatives. The use of the CD* test is illustrated with two empirical applications from the literature.
  JEL Classifications: C18, C23, C55
  Key Words: Latent factor models, strong and weak factors, error cross-sectional dependence, spatial and network alternatives, size and power
  Full Text: http://www.econ.cam.ac.uk/people-files/emeritus/mhp1/wp22/MHP_and_YX CDstar_Paper_Rev_August_23_2022.pdf
  Arxiv Link: http://arxiv.org/abs/2109.00408
  CESifo: https://www.cesifo.org/en/publikationen/2021/working-paper/bias-corrected-cd-test-error-cross-sectional-dependence-panel-data
  Data and Codes: http://www.econ.cam.ac.uk/people-files/emeritus/mhp1/wp21/codes_and_data_for_bias-corrected_CD_test.zip

   

• "Pooled Bewley Estimator of Long Run Relationships in Dynamic Heterogenous Panels", by Alexander Chudik, M. Hashem Pesaran, and Ron P. Smith, May 2021.

  Abstract: This paper, using the Bewley (1979) transformation of the autoregressive distributed lag model, proposes a pooled Bewley (PB) estimator of long-run coefficients for dynamic panels with heterogeneous short-run dynamics, in the same setting as the widely used Pooled Mean Group (PMG) estimator. The Bewley transform enables us to obtain an analytical closed form expression for the PB, which is not available when using the maximum likelihood approach. This lets us establish asymptotic normality of PB as n, T → ∞ jointly, allowing for applications with n and T large and of the same order of magnitude, but excluding panels where T is short relative to n. In contrast, asymptotic distribution of PMG estimator was obtained for n fixed and T → ∞. Allowing for both n and T large seems to be the more relevant empirical setting, as revealed by numerous applications of the PMG estimator in the literature. Dynamic panel estimators are biased when T is not sufficiently large. Three bias corrections (simulation based, split-panel jackknife, and a combined procedure) are investigated using Monte Carlo experiments, of which the combined procedure works best in reducing bias. In contrast to PMG, PB does not weight by estimated variances, which can make it more robust in small samples, though less efficient asymptotically. The PB estimator is illustrated with an application to the aggregate consumption function estimated in the original PMG paper.
  JEL Classifications: C12, C13, C23, C33
  Key Words: Heterogeneous dynamic panels; I(1) regressors; pooled mean group estimator (PMG), Autoregressive-Distributed Lag model (ARDL), Bewley transform, bias correction, split-panel jackknife.
  Full Text: http://www.econ.cam.ac.uk/people-files/emeritus/mhp1/wp21/PB_2021May27_paper_with_supplement.pdf
  Codes and Data: /people-files/emeritus/mhp1/wp21/PB_codes_and_data.zip

   

• "Variable Selection in High Dimensional Linear Regressions with Parameter Instability", by Alexander Chudik, M. Hashem Pesaran and Mahrad Sharifvaghe, July 2020, revised January 2023.

  Abstract: This paper is concerned with the problem of variable selection when the marginal effects of signals on the target variable as well as the correlation of the covariates in the active set are allowed to vary over time, without committing to any particular model of parameter instabilities. It poses the issue of whether weighted or unweighted observations should be used at the variable selection stage in the presence of parameter instability, particularly when the number of potential covariates is large. Amongst the extant variable selection approaches, we focus on the One Covariate at a time Multiple Testing (OCMT) method. This procedure allows a natural distinction between the selection and forecasting stages. We establish three main theorems on selection, estimation post selection, and in-sample fit. These theorems provide justification for using unweighted observations at the selection stage of OCMT and down-weighting of observations only at the forecasting stage. The benefits of the proposed method as compared to Lasso, Adaptive Lasso and Boosting are illustrated by Monte Carlo studies and empirical applications to forecasting monthly stock market returns and quarterly output growths.
  JEL Classifications: C22, C52, C53, C55
  Key Words: Parameter instability, High-dimensionality, Variable selection, One Covariate at a time Multiple Testing (OCMT)
  Full Text: http://www.econ.cam.ac.uk/people-files/emeritus/mhp1/wp23/CPS_OCMT_01_10_2023.pdf
  Codes and data: https://www.dropbox.com/scl/fo/wo1lmd2v46exfejy4mf8n/h?dl=0&rlkey=lfdd1nm9hpflknndrb2elfot4

   

• "The Role of Factor Strength and Pricing Errors for Estimation and Inference in Asset Pricing Models", by M. Hashem Pesaran and Ron P. Smith, CESifo Working Paper No. tbc, October 2019.

  Abstract: In this paper we are concerned with the role of factor strength and pricing errors in asset pricing models, and their implications for identification and estimation of risk premia. We establish an explicit relationship between the pricing errors and the presence of weak factors that are correlated with stochastic discount factor. We introduce a measure of factor strength, and distinguish between observed factors and unobserved factors. We show that unobserved factors matter for pricing if they are correlated with the discount factor, and relate the strength of the weak factors to the strength (pervasiveness) of non-zero pricing errors. We then show, that even when the factor loadings are known, the risk premia of a factor can be consistently estimated only if it is strong and if the pricing errors are weak. Similar results hold when factor loadings are estimated, irrespective of whether individual returns or portfolio returns are used. We derive distributional results for two pass estimators of risk premia, allowing for non-zero pricing errors. We show that for inference on risk premia the pricing errors must be sufficiently weak. We consider both when n (the number of securities) is large and T (the number of time periods) is short, and the case of large n and T. Large n is required for consistent estimation of risk premia, whereas the choice of short T is intended to reduce the possibility of time variations in the factor loadings. We provide monthly rolling estimates of the factor strengths for the three Fama-French factors over the period 1989-2018.
  JEL Classifications: C38, G12
  Key Words: Arbitrage Pricing Theory, APT, factor strength, identification of risk premia, two-pass regressions, Fama-French factors.
  Full Text: http://www.econ.cam.ac.uk/people-files/emeritus/mhp1/wp19/Factor-Strength-and-APT-October-16-2019.pdf

   

• "Business Cycle Effects of Credit Shocks in a DSGE Model with Firm Defaults", by M. Hashem Pesaran and TengTeng Xu, CWPE Working paper. No. 1159, CESifo Working Paper No. 3609, IZA Discussion Paper No. 6027, October 2011, revised April 2016

  Abstract: This paper proposes a new theoretical framework for the analysis of the relationship between credit shocks, firm defaults and volatility. The key feature of the modelling approach is to allow for the possibility of default in equilibrium. The model is then used to study the impact of credit shocks on business cycle dynamics. It is assumed that firms are identical ex ante but differ ex post due to different realizations of firm-specific technology shocks, possibly leading to default by some firms. The implications of firm defaults for the balance sheets of households and banks and their subsequent impacts on business uctuations are investigated within a dynamic stochastic general equilibrium framework. Results from a calibrated version of the model suggest that, in the steady state, a firm's default probability rises with its leverage ratio and the level of uncertainty in the economy. A positive credit shock, defined as a rise in the loan-to-deposit ratio, increases output, consumption, hours and productivity, and reduces the spread between loan and deposit rates. Interestingly, the effects of the credit shock tend to be highly persistent, even without price rigidities and habit persistence in consumption behavior.
  JEL Classifications: E32, E44, E50, G21.
  Key Words: Firm Defaults; Credit Shocks; Financial Intermediation; Interest Rate Spread; Uncertainty.
  Full Text: http://www.econ.cam.ac.uk/people-files/emeritus/mhp1/wp16/MacroCredit_PesaranXu_April-2016.pdf
  Supplement: http://www.econ.cam.ac.uk/people-files/emeritus/mhp1/wp11/MacroCredit_ 5Oct2011_Supplement.pdf

   

• "Optimality and Diversifiability of Mean Variance and Arbitrage Pricing Portfolios", by M. Hashem Pesaran, and Paolo Zaffaroni, CESifo Working Papers No. 2857, October, 2009

  Abstract: This paper investigates the limit properties of mean-variance (mv) and arbitrage pricing (ap) trading strategies using a general dynamic factor model, as the number of assets diverge to infinity. It extends the results obtained in the literature for the exact pricing case to two other cases of asymptotic no-arbitrage and the unconstrained pricing scenarios. The paper characterizes the asymptotic behaviour of the portfolio weights and establishes that in the non-exact pricing cases the ap and mv portfolio weights are asymptotically equivalent and, moreover, functionally independent of the factors conditional moments. By implication, the paper sheds light on a number of issues of interest such as the prevalence of short-selling, the number of dominant factors and the granularity property of the portfolio weight.
  JEL Classifications: Large Portfolios, Factor Models, Mean-Variance Portfolio, Arbitrage Pricing, Market (Beta) Neutrality, Well Diversification.
  Key Words: C32, C52, C53, G11.
  Full Text: http://www.econ.cam.ac.uk/people-files/emeritus/mhp1/wp09/pz_port_17_October_09.pdf