THE ERRORS IN THE VARIABLES PROBLEM IN THE CROSS-SECTION OF EXPECTED STOCK RETURNS

Recent research has documented the failure of market beta to capture the cross-section of expected returns within the context of a two-pass estimation methodology. However, the two-pass methodology suffers from the errors-in-variables (ETV) problem that could attenuate the apparent significance of market beta. This article provides a new correction for the ETV problem that is robust: to conditional heteroscedasticity. After the correction, I find more support for the role of market beta and less support for the role of firm size in explaining the cross-section of expected returns. While the EIV correction leads to a diminished role of firm size, the size variable remains a significant force in explaining the cross-section of expected returns.