Improved Generalized Method of Moments (GMMd), Liquidity Risk, and the Pastor-Stambaugh Extension of the Fama-French Model

Abstract

This paper uses an instrumental variable technique to minimize the specification errors in the Pástor-Stambaugh (PS) extension of the Fama-French (FF) model. In particular, we use an improvement of Hansen’s generalized method of moments that uses higher moments, which we call GMMd. Results with this GMMd estimator indicate that the liquidity measure used in the PS extension of the FF model is improperly measured and/or is ill-conceived.