Spurious Regressions in Financial Economics.pdf

Spurious Regressions in Financial Economics? Wayne E. Ferson University of Washington and NBER Sergei Sarkissian McGill University Timothy Simin University of Washington first draft: February 14, 1998 this revision: August 4, 1999 ABSTRACT We study biases associated with regression models in which persistent lagged variables predict stock returns, either linearly or in interaction with contemporaneous values of a market index return. We focus on the issue of spurious regression, related to the classic studies of Yule (1926) and Granger and Newbold (1974). We find that spurious regression is a concern in regressions of stock returns on persistent lagged instruments, especially when the predictable component of returns is large. In regressions where the lagged instruments interact with a market index return, the spurious regression problem is not as severe. Without persistent time-variation in the expected market return and beta, spurious regression bias is not an important issue. However, when a common persistent factor drives expected market returns and betas, spurious regression becomes a concern. Large sample sizes are no defense against the spurious regression bias. Ferson and Simin are from the University of Washington School of Business Administration, Department of Finance and Business Economics, Box 353200, Seattle, Washington 98195-3200. Ferson may be reached at ph: (206) 543-1843, fax 685-9392, /apmodels. Sarkissian may be reached at Faculty of Management, 1001 Sherbrooke Street West, McGill University, Montreal, PQ, Canada H3A 1G5, ph. (514) 398-4876, fax 398-3876, ss@management.mcgill.ca. Simin may be reached at tsimin@, (206) 543-4773. We are grateful t