The Pástor-Stambaugh Empirical Model Revisited: Evidence from Robust Instruments

Abstract

This paper uses a new parsimonious and robust instrumental variables technique to minimize the specification errors in the Pástor-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. 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 new 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. Keywords: GMM; specification errors; robust instrumental variables; higher moments; Pástor-Stambaugh; liquidity risk.