Capturing the impact of unobserved sector-wide shocks on stock returns with panel data model

Kihoon Jimmy Hong, Bin Peng, Xiaohui Zhang

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Abstract

Unobserved sector-wide common shocks cause the issue of cross-sectional dependence (CSD) in panel data modelling of stock returns. In this study we apply two econometric techniques: the seemingly unrelated regression approach and a Bayesian estimator for panel data models with factor structural errors, to allow for CSD within a particular sector. By applying these models to monthly stock returns of S&P100 companies from six sectors over 10 years, we can capture and measure the heterogeneous impacts of not only observed individual company accounting fundamentals and market-wide common shocks, but also unobservable sector-wide common shocks. Results from the empirical study show that the impacts from both observed factors and unobserved sector-wide common shocks vary markedly across companies. After controlling for observed accounting fundamentals and market-wide common factors, a considerable proportion of the variation in stock returns can be attributed to unobservable sector-wide common shocks.

Original languageEnglish
Pages (from-to)495-508
Number of pages14
JournalEconomic Record
Volume91
Issue number295
DOIs
Publication statusPublished - Dec 2015
Externally publishedYes

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