Scientific article
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A Penalized Two-Pass Regression to Predict Stock Returns with Time-Varying Risk Premia

Published inJournal of econometrics, p. 48
First online date2021
Abstract

We develop a penalized two-pass regression with time-varying factor loadings. The penalization in the first pass enforces sparsity for the time-variation drivers while also maintaining compatibility with the no-arbitrage restrictions by regularizing appropriate groups of coefficients. The second pass delivers risk premia estimates to predict equity excess returns. Our Monte Carlo results and our empirical results on a large cross-sectional data set of US individual stocks show that penalization without grouping can yield to nearly all estimated time-varying models violating the no-arbitrage restrictions. Moreover, our results demonstrate that the proposed method reduces the prediction errors compared to a penalized approach without appropriate grouping or a time-invariant factor model.

Keywords
  • Two-pass regression
  • Predictive modeling
  • Large panel
  • Factor model
  • LASSO penalization
Citation (ISO format)
BAKALLI, Gaetan, GUERRIER, Stéphane, SCAILLET, Olivier. A Penalized Two-Pass Regression to Predict Stock Returns with Time-Varying Risk Premia. In: Journal of econometrics, 2021, p. 48. doi: 10.2139/ssrn.3777215
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Article (Published version)
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Additional URL for this publicationhttps://www.ssrn.com/abstract=3777215
Journal ISSN0304-4076
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Technical informations

Creation14/08/2026 00:34:30
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