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FRM Part I · FRM Exam Part I · Regression Diagnostics

An analyst regresses monthly fund returns on the market excess return but leaves out a size factor that actually affects fund returns. The size factor is positively correlated with the market excess return, and its true coefficient is positive. What is the most likely effect on the estimated market beta?

The estimated market beta is biased upward. The omitted size factor has a positive effect on returns and is positively correlated with the market excess return, so the included beta picks up part of the size effect, producing positive omitted variable bias.

  1. AIt is biased upwardCorrect
  2. BIt is biased downward
  3. CIt is unbiased but has a larger standard error
  4. DIt is unbiased and consistent

Explanation

Omitted variable bias has the sign of (true coefficient of omitted variable) x (correlation between omitted and included variable). Both are positive, so the bias is positive. The market beta absorbs part of the size effect and is overstated.

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