The Pástor-Stambaugh empirical model revisited: Evidence from robust instruments

Abstract

This article uses a parsimonious and robust instrumental variables technique to minimize the specification errors in the Pastor-Stambaugh (PS) empirical model. In particular, we use an improvement of Hansen’s generalized method of moments (GMM) that uses higher moments that are robust instruments. We also propose a robustness test for these instruments. Results with these instruments indicate that the liquidity measure used in the PS empirical model is improperly measured and/or is ill-conceived. Although this article applies a GMM framework to a financial application, this technique is applicable to estimation problems in the presence of specification errors in all areas of quantitative finance.