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What is Fama-MacBeth methodology?

What is Fama-MacBeth methodology?

Business

The Fama-MacBeth (FM) methodology, a two-step regression technique that estimates the relationship between multiple independent variables and a dependent variable. Proposed by Eugene Fama and James MacBeth in their 1973 paper “Risk, Return, and Equilibrium: Empirical Tests,” and has since become a popular approach in financial econometrics and other fields.

The FM methodology involves two steps:

  1. Cross-sectional regression: In the first step, a separate regression is run for each time period. Moreover, with the dependent variable being the return on an asset or portfolio. And the independent variables becoming various risk factors or other explanatory variables. The coefficients estimated in each regression capture the cross-sectional relationship between the independent variables and the dependent variable in that time period.
  2. Time-series regression: In the second step, the coefficients estimated in the first step become treated as the “observations” in a time-series regression. With the dependent variable becoming the average return across all time periods. In addition, the independent variables becoming the coefficients estimated in step 1. This step estimates the time-series relationship between the independent variables and the dependent variable.

In conclusion, the FM methodology has several advantages over other regression techniques, such as panel data regression or pooled OLS regression. Lastly, allows for time-varying coefficients, accounts for heteroscedasticity, and provides more efficient estimates of the coefficients. Additionally, it can become used with relatively small samples, as it does not require a large number of time periods.

What is Fama-MacBeth methodology?