FNCE 926

Empirical Methods in CF
Lecture 9 – Common Limits & Errors

Professor Todd Gormley

Announcements
n  Rough draft of research proposal due
q  Should have uploaded to Canvas
q  I’ll try to e-mail feedback by next week

2
Background readings for today
n  Ali, Klasa, and Yeung (RFS 2009)
n  Gormley and Matsa (RFS 2014)

3
Outline for Today
n  Quick review of last lecture on RDD
n  Discuss common limitations and errors
q  Our data isn’t perfect
q  Hypothesis testing mistakes
q  How not to control for unobserved heterogeneity

n  Student presentations of “RDD” papers

4
Quick Review[Part 1]

n  What is difference between “sharp” and

“fuzzy” regression discontinuity design (RDD)?
q  Answer = With “sharp”, change in treatment status
only depends on x and cutoff x’; with “fuzzy”, only
probability of treatment varies at cutoff

5
Quick Review[Part 2]
n  Estimation of sharp RDD
yi = α + β di + f ( xi − x ') + di × g ( xi − x ') + ui

q  di = indicator for x ≥ x’

q  f( ) and g( ) are polynomial functions that
control for effect of x on y
q  Can also do analysis in tighter window
around threshold value x’

6
Quick Review[Part 3]
n  Estimation of fuzzy RDD is similar…
yi = α + β di + f ( xi − x ') + ui

But use Ti and as instrument for di where

q  Ti is indicator for x ≥ x’
q  And, di is indicator for treatment

7
Quick Review [Part 4]
n  What are some standard internal validity tests
you might want to run with RDD?
q  Answers:
n  Check robustness to different polynomial orders
n  Check robustness to bandwidth
n  Graphical analysis to show discontinuity in y
n  Compare other characteristics of firms around cutoff
threshold to make sure no other discontinuities
n  And more…

8
Quick Review [Part 5]
n  If effect of treatment is heterogeneous,
how does this affect interpretation of RDD
estimates?
q  Answer = They take on local average
treatment effect interpretation, and fuzzy RDD
captures only effect of compliers. Neither is
problem for internal validity, but can
sometimes limit external validity of finding

9
Common Limitations & Errors – Outline
n  Data limitations
n  Hypothesis testing mistakes
n  How to control for unobserved heterogeneity

10
Data limitations
n  The data we use is almost never perfect
q  Variables are often reported with error
q  Exit and entry into dataset typically not random
q  Datasets only cover certain types of firms

11
Measurement error – Examples
n  Variables are often reported with error
q  Sometimes it is just innocent noise
n  E.g. Survey respondents self report past income
with error [because memory isn’t perfect]

q  Sometimes, it is more systematic

n  E.g. survey might ask teenagers # of times
smoked marijuana, but teenagers that have
smoked and have high GPA might say zero

n  How will these errors affect analysis?

12
Measurement error – Why it matters
n  Answer = Depends; but in general, hard
to know exactly how this will matter
q  If y is mismeasured…
n  If only random noise, just makes SEs larger
n  But if systematic in some way [as in second example],
can cause bias if error is correlated with x’s
q  If x is mismeasured…
n  Even simple CEV causes attenuation bias on
mismeasured x and biases on all other variables

13
Measurement error – Solution
n  Standard measurement error solutions
apply [see “Causality” lecture]
q  Though admittedly, measurement error is
difficult to deal with unless know exactly
source and nature of the error

14
Survivorship Issues – Examples
n  In other cases, observations are included
or missing for systematic reasons; e.g.
q  Ex. #1 – Firms that do an IPO and are
added to datasets that cover public firms may
be different than firms that do not do an IPO
q  Ex. #2 – Firms adversely affected by some
event might subsequently drop out of data
because of distress or outright bankruptcy
n  How can these issues be problematic?

15
Survivorship Issues – Why it matters
n  Answer = There is a selection bias,
which can lead to incorrect inferences
q  Ex. #1 – E.g. going public may not cause
high growth; it’s just that the firms going
public were going to grow faster anyway
q  Ex. #2 – Might not find adverse effect of
event (or might understate it’s effect) if some
affected firms go bankrupt and are dropped

16
Survivorship Issues – Solution
n  Again, no easy solutions; but, if worried
about survivorship bias…
q  Check whether treatment (in diff-in-diff) is
associated with observations being more or
less likely to drop from data
q  In other analysis, check whether covariates
of observations that drop are systematically
different in a way that might be important

17
Sample is limited – Examples

n  Observations in commonly used datasets

are often limited to certain firms
q  Ex. #1 – Compustat covers largest public firms
q  Ex. #2 – Execucomp only provides incentives
on CEOs of firms listed on S&P 1500

n  How this might affect our analysis?

18
Sample is limited – Why it matters

n  Answer = Need to be careful when

making claims about external validity
q  Ex. #1 – Might find no effect of treatment in
Compustat because treatment effect is greatest
for unobserved, smaller, private firms
q  Ex. #2 – Observed correlations between
incentives and risk-taking in Execucomp
might not hold for smaller firms

19
Sample is limited – Solution

n  Be careful with inferences to avoid

making claims that lack external validity
n  Argue that your sample is representative
of economically important group
n  Hand-collect your own data if theory
your interested in testing requires it!
q  This can actually make for a great paper and
is becoming increasingly important in finance

20
Interesting Example of Data Problem

n  Ali, Klasa, and Yeung (RFS 2009) provide

interesting example of data problem
q  They note the following…
n  Many theories argue that “industry concentration”
is important factor in many finance settings
n  But researchers measure industry concentration
(i.e. herfindahl index) using Compustat

q  How might this be problematic?

21
Ali, et al. – Example data problem [P1]

n  Answer = Systematic measurement error!

q  Compustat doesn’t include private firms; so
using it causes you to mismeasure concentration
q  Ali, et al. find evidence of this by calculating
concentration using U.S. Census data
n  Correlation between measures is just 13%
n  Moreover, error in Compustat measure is
systematically related to some key variables, like
turnover of firms in the industry

22
Ali, et al. – Example data problem [P2]
n  Ali, et al. (RFS 2009) found it mattered;
using Census measure overturns four
previously published results
q  E.g. Concentration is positively related to R&D,
not negatively related as previously argued
q  See paper for more details...

23
Common Limitations & Errors – Outline
n  Data limitations
n  Hypothesis testing mistakes
n  How to control for unobserved heterogeneity

24
Hypothesis testing mistakes
n  As noted in lecture on natural experiments,
triple-difference can be done by running
double-diff in two separate subsamples
q  E.g. estimate effect of treatment on small firms;
then estimate effect of treatment on large firms

25
Example inference from such analysis
Small   Large   Low  D/E   High  D/E  
                                     Sample  =  
Firms Firms Firms Firms
Treatment  *  Post 0.031 0.104** 0.056 0.081***
(0.121) (0.051) (0.045) (0.032)

N 2,334 3,098 2,989 2,876

R-­‐squared 0.11 0.15 0.08 0.21
Firm  dummies X X X X
Year  dummies X X X X

q  From above results, researcher often concludes…

n  “Treatment effect is larger for bigger firms” Do you see any
n  “High D/E firms respond more to treatment” problem with
either claim?

26
Be careful making such claims!

n  Answer = Yes! The difference across subsamples

may not actually be statistically significant!
q  Hard to know if different just eyeballing it because
whether difference is significant depends on
covariance of the two separate estimates

n  How can you properly test these claims?

27
Example triple interaction result

All  
                                     Sample  =  
Firms
Treatment  *  Post 0.031
(0.121)
Difference is not actually
Treatment  *  Post  *  Large 0.073
(0.065)
statistically significant

N 5,432
R-­‐squared 0.12 Remember to interact year
Firm  dummies X dummies & triple difference;
Year  dummies X
otherwise, estimates won’t
Year  *  Large  dummies X
match earlier subsamples

28
Practical Advice
n  Don’t make claims you haven’t tested;
they could easily be wrong!
q  Best to show relevant p-values in text or tables
for any statistical significance claim you make
q  If difference isn’t statistically significant
[e.g. p-value = 0.15], can just say so; triple-diffs
are noisy, so this isn’t uncommon
q  Or, be more careful in your wording…
n  I.e. you could instead say, “we found an effect for large
firms, but didn’t find much evidence for small firms”

29
Common Limitations & Errors – Outline
n  Data limitations
n  Hypothesis testing mistakes
n  How to control for unobserved heterogeneity
q  How not to control for it
q  General implications
q  Estimating high-dimensional FE models

30
Unobserved Heterogeneity – Motivation
n  Controlling for unobserved heterogeneity is a
fundamental challenge in empirical finance
q  Unobservable factors affect corporate policies and prices
q  These factors may be correlated with variables of interest

n  Important sources of unobserved heterogeneity are

often common across groups of observations
q  Demand shocks across firms in an industry,
differences in local economic environments, etc.

31
Many different strategies are used
n  As we saw earlier, FE can control for unobserved
heterogeneities and provide consistent estimates
n  But, there are other strategies also used to control
for unobserved group-level heterogeneity…
q  “Adjusted-Y” (AdjY) – dependent variable is
demeaned within groups [e.g. ‘industry-adjust’]
q  “Average effects” (AvgE) – uses group mean of
dependent variable as control [e.g. ‘state-year’ control]

32
AdjY and AvgE are widely used
n  In JF, JFE, and RFS…
q  Used since at least the late 1980s
q  Still used, 60+ papers published in 2008-2010
q  Variety of subfields; asset pricing, banking,
capital structure, governance, M&A, etc.

n  Also been used in papers published in

the AER, JPE, and QJE and top
accounting journals, JAR, JAE, and TAR

33
But, AdjY and AvgE are inconsistent

n  As Gormley and Matsa (2014) shows…

q  Both can be more biased than OLS
q  Both can get opposite sign as true coefficient
q  In practice, bias is likely and trying to predict its
sign or magnitude will typically be impractical

n  Now, let’s see why they are wrong…

34
The underlying model [Part 1]
n  Recall model with unobserved heterogeneity
yi , j = β X i , j + fi + ε i , j

q  i indexes groups of observations (e.g. industry);

j indexes observations within each group (e.g. firm)
n  yi,j = dependent variable
n  Xi,j = independent variable of interest
n  fi = unobserved group heterogeneity
n  ε i , j = error term

35
The underlying model [Part 2]

n  Make the standard assumptions:

N groups, J observations per group,
where J is small and N is large
X and ε are i.i.d. across groups, but
not necessarily i.i.d. within groups
var( f ) = σ 2f , µ f = 0
var( X ) = σ X2 , µ X = 0
Simplifies some expressions,
var(ε ) = σ ε , µε = 0
2
but doesn’t change any results

36
The underlying model [Part 3]

n  Finally, the following assumptions are made:

cov( f i , ε i , j ) = 0
co v( X i , j , ε i , j ) = co v( X i , j , ε i , − j ) = 0
cov( X i , j , f i ) = σ Xf ≠ 0
What do these imply?
Answer = Model is correct in that
if we can control for f, we’ll
properly identify effect of X; but
if we don’t control for f there will
be omitted variable bias

37
We already know that OLS is biased
True model is: yi , j = β X i , j + fi + ε i , j

But OLS estimates: yi , j = β OLS X i , j + uiOLS

,j

q  By failing to control for group effect, fi, OLS

suffers from standard omitted variable bias
σ Xf
βˆ OLS = β +
σ X2

Alternative estimation strategies are required…

38
Adjusted-Y (AdjY)
n  Tries to remove unobserved group heterogeneity by
demeaning the dependent variable within groups

AdjY estimates: yi , j − yi = β X i , j + uiAdjY

AdjY
,j

1
where yi =
J
∑ (β X
k ∈group i
i,k + fi + ε i ,k )

Note: Researchers often exclude observation at hand when

calculating group mean or use a group median, but both
modifications will yield similarly inconsistent estimates

39
Example AdjY estimation

n  One example – firm value regression:

Qi , j ,t − Qi ,t = α + β ' Xi, j ,t + ε i , j ,t
Qi , j ,t
q  = Tobin’s Q for firm j, industry i, year t
q  Qi ,t = mean of Tobin’s Q for industry i in year t
q  Xijt = vector of variables thought to affect value
q  Researchers might also include firm & year FE

Anyone know why AdjY is going to be inconsistent?

40
Here is why…
n  Rewriting the group mean, we have:
yi = fi + β X i + ε i ,

n  Therefore, AdjY transforms the true data to:

yi , j − yi = β X i , j − β X i + ε i , j − ε i

What is the AdjY estimation forgetting?

41
AdjY can have omitted variable bias
n  β̂ adjY can be inconsistent when β ≠ 0
True model: yi , j − yi = β X i , j − β X i + ε i , j − ε i
y
But, AdjY estimates: i , j − yi = β AdjY
X i, j + u AdjY
i, j

q  By failing to control for X i , AdjY suffers

from omitted variable bias when σ XX ≠ 0
σ XX In practice, a positive
βˆ AdjY = β − β
σ X2 covariance between X
and X will be common;
e.g. industry shocks

42
Now, add a second variable, Z

n  Suppose, there are instead two RHS variables

True model: yi , j = β X i , j + γ Zi , j + fi + ε i , j

n  Use same assumptions as before, but add:

cov( Z i , j , ε i , j ) = cov( Z i , j , ε i , − j ) = 0
var( Z ) = σ Z2 , µ Z = 0
cov( X i , j , Z i , j ) = σ XZ
cov( Z i , j , f i ) = σ Zf

43
AdjY estimates with 2 variables
n  With a bit of algebra, it is shown that:

⎡ β (σ XZ σ ZX − σ Z2σ XX ) + γ (σ XZ σ ZZ − σ Z2σ XZ ) ⎤
⎢β + ⎥
⎡ βˆ ⎤ ⎢
AdjY
σ Z σ X − σ XZ
2 2 2
⎥
⎢ AdjY ⎥ = ⎢ ⎥
⎢⎣γˆ ⎥⎦ ⎢ β (σ σ
XZ XX − σ X ZX )
2
σ + γ (σ σ
XZ XZ − σ X ZZ ) ⎥
2
σ
⎢γ + σ σ
2 2
− σ 2 ⎥
⎣ Z X XZ ⎦

Estimates of both Determining sign and

β and γ can be magnitude of bias will
inconsistent typically be difficult

44
Average Effects (AvgE)

n  AvgE uses group mean of dependent variable

as control for unobserved heterogeneity
AvgE estimates: yi , j = β AvgE X i , j + γ AvgE yi + uiAvgE
,j

45
Average Effects (AvgE)

n  Following profit regression is an AvgE example:

ROAi ,s,t = α + β ' Xi,s,t + γ ROAs,t + ε i ,s,t

q  ROAs,t = mean of ROA for state s in year t

q  Xist = vector of variables thought to profits
q  Researchers might also include firm & year FE

Anyone know why AvgE is going to be inconsistent?

46
AvgE has measurement error bias

n  AvgE uses group mean of dependent variable

as control for unobserved heterogeneity
AvgE estimates: yi , j = β AvgE X i , j + γ AvgE yi + uiAvgE
,j

Recall, true model: yi , j = β X i , j + fi + ε i , j

Problem is that yi measures fi with error

47
AvgE has measurement error bias
n  Recall that group mean is given by yi = fi + β X i + ε i ,
q  Therefore, yi measures fi with error − β X i − ε i
q  As is well known, even classical measurement error
causes all estimated coefficients to be inconsistent

n  Bias here is complicated because error can be

correlated with both mismeasured variable, fi ,
and with Xi,j when σ XX ≠ 0

48
AvgE estimate of β with one variable

n  With a bit of algebra, it is shown that:

βˆ AvgE = β +
( ) (
σ Xf βσ fX + β 2σ X2 + σ ε2 − σ εε − βσ XX σ 2f + βσ fX + σ εε )
( )
σ X2 σ 2f + 2βσ fX + β 2σ X2 + σ ε2 − (σ Xf + βσ XX )
2

Determining
magnitude and Covariance between X and X
again problematic, but not Even non-i.i.d.
direction of bias
needed for AvgE estimate to nature of errors
is difficult
be inconsistent can affect bias!

49
Comparing OLS, AdjY, and AvgE
n  Can use analytical solutions to compare
relative performance of OLS, AdjY, and AvgE
n  To do this, we re-express solutions…
q  We use correlations (e.g. solve bias in terms of
correlation between X and f, ρ Xf , instead of σ Xf )
q  We also assume i.i.d. errors [just makes bias of
AvgE less complicated]
q  And, we exclude the observation-at-hand when
calculating the group mean, X i , …

50
Why excluding Xi doesn’t help
n  Quite common for researchers to exclude
observation at hand when calculating group mean
q  It does remove mechanical correlation between X and
omitted variable, X i , but it does not eliminate the bias
q  In general, correlation between X and omitted variable, X i ,
is non-zero whenever X i is not the same for every group i
q  This variation in means across group is almost
assuredly true in practice; see paper for details

51
ρXf has large effect on performance
Estimate, β̂ AdjY more biased
than OLS, except for
True β = 1
2

large values for ρXf OLS

1

AdjY
0

AvgE gives
wrong sign for Other parameters held constant
AvgE low values of ρXf
-1

σ f / σ X = σ ε / σ X = 1, J = 10, ρ X , X = 0.5
i −i
-2

-0.75 -0.5 -0.25 0 0.25 0.5 0.75

ρ Xf
52
 More observations need not help!
Estimate, β̂
OLS
1.25
1

AvgE
0.75

AdjY
0.5

0 5 10 15 20 25
σ f / σ X = σ ε / σ X = 1, ρ X , X = 0.5, ρ Xf = 0.25 J
i −i

53
Summary of OLS, AdjY, and AvgE

n  In general, all three estimators are inconsistent

in presence of unobserved group heterogeneity
n  AdjY and AvgE may not be an improvement
over OLS; depends on various parameter values

n  AdjY and AvgE can yield estimates with

opposite sign of the true coefficient

54
Fixed effects (FE) estimation
n  Recall: FE adds dummies for each group to OLS
estimation and is consistent because it directly
controls for unobserved group-level heterogeneity
n  Can also do FE by demeaning all variables with respect
to group [i.e. do ‘within transformation’] and use OLS

y
FE estimates: i , j − yi = β FE
( i, j i ) i, j
X − X + u FE

True model: yi , j − yi = β ( X i , j − X i ) + (ε i , j − ε i )

55
Comparing FE to AdjY and AvgE
n  To estimate effect of X on Y controlling for Z
q  One could regress Y onto both X and Z… Add group FE
q  Or, regress residuals from regression of Y on Z
onto residuals from regression of X on Z Within-group
transformation!
§  AdjY and AvgE aren’t the same as finding the
effect of X on Y controlling for Z because...
§  AdjY only partials Z out from Y
§  AvgE uses fitted values of Y on Z as control

56
The differences will matter! Example #1
n  Consider the following capital structure regression:
( D / A)i ,t = α + βXi,t + fi + ε i ,t
q  (D/A)it = book leverage for firm i, year t
q  Xit = vector of variables thought to affect leverage
q  fi = firm fixed effect

n  We now run this regression for each approach to

deal with firm fixed effects, using 1950-2010 data,
winsorizing at 1% tails…

57
Estimates vary considerably
De p e n d e n t variab le = b o o k le ve rag e

OLS Adj Y Avg E FE

Fixed  Assets/  Total  Assets 0.270*** 0.066*** 0.103*** 0.248***

(0.008) (0.004) (0.004) (0.014)
Ln(sales) 0.011*** 0.011*** 0.011*** 0.017***
(0.001) 0.000 0.000 (0.001)
Return  on  Assets -­‐0.015*** 0.051*** 0.039*** -­‐0.028***
(0.005) (0.004) (0.004) (0.005)
Z-­‐score -­‐0.017*** -­‐0.010*** -­‐0.011*** -­‐0.017***
0.000 (0.000) (0.000) (0.001)
Market-­‐to-­‐book  Ratio -­‐0.006*** -­‐0.004*** -­‐0.004*** -­‐0.003***
(0.000) (0.000) (0.000) (0.000)

Observations 166,974 166,974 166,974 166,974

R-­‐squared 0.29 0.14 0.56 0.66

58
The differences will matter! Example #2

n  Consider the following firm value regression:

Qi , j ,t = α + β ' Xi, j ,t + f j ,t + ε i , j ,t

q  Q = Tobin’s Q for firm i, industry j, year t

q  Xijt = vector of variables thought to affect value
q  fj,t = industry-year fixed effect

n  We now run this regression for each approach

to deal with industry-year fixed effects…

59
Estimates vary considerably
Dependent  Variable  =  Tobin's  Q
OLS Adj Y Avg E FE

Delaware  Incorporation 0.100*** 0.019 0.040 0.086**

(0.036) (0.032) (0.032) (0.039)
Ln(sales) -­‐0.125*** -­‐0.054*** -­‐0.072*** -­‐0.131***
(0.009) (0.008) (0.008) (0.011)
R&D  Expenses  /  Assets 6.724*** 3.022*** 3.968*** 5.541***
(0.260) (0.242) (0.256) (0.318)
Return  on  Assets -­‐0.559*** -­‐0.526*** -­‐0.535*** -­‐0.436***
(0.108) (0.095) (0.097) (0.117)

Observations 55,792 55,792 55,792 55,792

R-­‐squared 0.22 0.08 0.34 0.37

60
Common Limitations & Errors – Outline
n  Data limitations
n  Hypothesis testing mistakes
n  How to control for unobserved heterogeneity
q  How not to control for it
q  General implications
q  Estimating high-dimensional FE models

61
General implications

n  With this framework, easy to see that other

commonly used estimators will be biased

62
Other AdjY estimators are problematic
n  Same problem arises with other AdjY estimators
q  Subtracting off median or value-weighted mean
q  Subtracting off mean of matched control sample
[as is customary in studies if diversification “discount”]
q  Comparing “adjusted” outcomes for treated firms pre-
versus post-event [as often done in M&A studies]
q  Characteristically adjusted returns [as used in asset pricing]

63
AdjY-type estimators in asset pricing
n  Common to sort and compare stock returns across
portfolios based on a variable thought to affect returns
n  But, returns are often first “characteristically adjusted”
q  I.e. researcher subtracts the average return of a benchmark
portfolio containing stocks of similar characteristics
q  This is equivalent to AdjY, where “adjusted returns” are
regressed onto indicators for each portfolio

n  Approach fails to control for how avg. independent

variable varies across benchmark portfolios

64
Asset Pricing AdjY – Example
n  Asset pricing example; sorting returns based
on R&D expenses / market value of equity
Characteristically  adjusted  returns  by  R&D  Quintile  (i.e.,  Adj Y)
Missing Q1 Q2 Q3 Q4 Q5
-­‐0.012*** -­‐0.033*** -­‐0.023*** -­‐0.002 0.008 0.020***
(0.003) (0.009) (0.008) (0.007) (0.013) (0.006)

Difference between
We use industry-size benchmark portfolios Q5 and Q1 is 5.3
and sorted using R&D/market value percentage points

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Estimates vary considerably
Dependent  Variable  =  Yearly  Stock  Return
Adj Y FE
R&D  Missing 0.021** 0.030***
(0.009) (0.010) Same AdjY result,
R&D  Quintile  2 0.01 0.019 but in regression
(0.013) (0.014) format; quintile 1
R&D  Quintile  3 0.032*** 0.051*** is excluded
(0.012) (0.018)
R&D  Quintile  4 0.041*** 0.068***
(0.015) (0.020) Use benchmark-period
R&D  Quintile  5 0.053*** 0.094*** FE to transform both
(0.011) (0.019) returns and R&D; this is
Observations 144,592 144,592 equivalent to double sort
2
R 0.00 0.47

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What if AdjY or AvgE is true model?
§  If data exhibited structure of AvgE estimator,
this would be a peer effects model
[i.e. group mean affects outcome of other members]
§  In this case, none of the estimators (OLS, AdjY,
AvgE, or FE) reveal the true β [Manski 1993;
Leary and Roberts 2010]

§  Even ifinterested in studying yi , j − y i , AdjY

only consistent if Xi,j does not affect yi,j

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Common Limitations & Errors – Outline
n  Data limitations
n  Hypothesis testing mistakes
n  How to control for unobserved heterogeneity
q  How not to control for it
q  General implications
q  Estimating high-dimensional FE models

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Multiple high-dimensional FE

n  Researchers occasionally motivate using

AdjY and AvgE because FE estimator is
computationally difficult to do when there
are more than one FE of high-dimension

Now, let’s see why this is

(and isn’t) a problem…

69
LSDV is usually needed with two FE

n  Consider the below model with two FE

Two separate
yi , j ,k = β X i , j ,k + fi + δ k + ε i , j ,k group effects

q  Unless panel is balanced, within transformation can

only be used to remove one of the fixed effects
q  For other FE, you need to add dummy variables
[e.g. add time dummies and demean within firm]

70
Why such models can be problematic

n  Estimating FE model with many dummies

can require a lot of computer memory
q  E.g., estimation with both firm and 4-digit
industry-year FE requires ≈ 40 GB of memory

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This is growing problem

n  Multiple unobserved heterogeneities

increasingly argued to be important
q  Manager and firm fixed effects in executive
compensation and other CF applications
[Graham, Li, and Qui 2011, Coles and Li 2011]
q  Firm and industry×year FE to control for
industry-level shocks [Matsa 2010]

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But, there are solutions!

n  There exist two techniques that can be

used to arrive at consistent FE estimates
without requiring as much memory
#1 – Interacted fixed effects
#2 – Memory saving procedures

73
#1 – Interacted fixed effects
n  Combine multiple fixed effects into one-
dimensional set of fixed effect, and remove
using within transformation
q  E.g. firm and industry-year FE could be
replaced with firm-industry-year FE

But, there are limitations…

q  Can severely limit parameters you can estimate
q  Could have serious attenuation bias

74
#2 – Memory-saving procedures
n  Use properties of sparse matrices to reduce
required memory, e.g. Cornelissen (2008)
n  Or, instead iterate to a solution, which
eliminates memory issue entirely, e.g.
Guimaraes and Portugal (2010)
q  See paper for details of how each works
q  Both can be done in Stata using user-written
commands FELSDVREG and REGHDFE

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These methods work…

n  Estimated typical capital structure

regression with firm and 4-digit
industry×year dummies
q  Standard FE approach would not work; my
computer did not have enough memory…
q  Sparse matrix procedure took 8 hours…
q  Iterative procedure took 5 minutes

76
Summary of Today [Part 1]

n  Our data isn’t perfect…

q  Watch for measurement error
q  Watch for survivorship bias
q  Be careful about external validity claims

n  Make sure to test that estimates across

subsamples are actually statistically different

77
Summary of Today [Part 2]

n  Don’t use AdjY or AvgE!

n  But, do use fixed effects
q  Should use benchmark portfolio-period FE in
asset pricing rather than char-adjusted returns
q  Use iteration techniques to estimate models with
multiple high-dimensional FE

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In First Half of Next Class
n  Matching
q  What it does…
q  And, what it doesn’t do

n  Related readings… see syllabus

79
Assign papers for next week…
n  Gormley and Matsa (working paper, 2015)
q  Corporate governance & playing it safe preferences

n  Ljungqvist, Malloy, Marston (JF 2009) No comments

needed from
q  Data issues in I/B/E/S other groups

n  Bennedsen, et al. (working paper, 2012)

q  CEO hospitalization events

80
Break Time
n  Let’s take our 10 minute break
n  We’ll do presentations when we get back

81