The First-Stage in an Instrumental Variable Approach to Controlling for Endogenous

question 16

Multiple Choice

The first-stage in an instrumental variable approach to controlling for endogenous independent variables is to

• A)regress the endogenous independent variable on the instrument and all of the remaining independent variables and using those estimates to calculate predicted values of the endogenous variable.
• B)regress the endogenous variable on the instrument and all of the remaining independent variables and using those estimates to calculate the residuals.
• C)estimate the original population regression model with the predicted values of the endogenous variable substituted for the observed values of the endogenous variable.
• D)estimate the original population regression model with the predicted residuals included as an independent variable.

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Definitions:

HML Beta

A measure of sensitivity to the HML (High Minus Low) factor, part of the Fama-French three-factor model, indicating how much a stock's return is affected by the value premium.

Risk Premium

The additional return expected on an investment for taking on higher risk compared to a risk-free asset.

SMB Beta

A measure used in financial models to estimate the sensitivity of a stock’s return relative to the return of a small-minus-big (SMB) factor, part of the Fama-French three-factor model.

HML Beta

A measure of sensitivity relative to the HML (High Minus Low) factor, part of the Fama-French three-factor model, indicating how much a stock's return is affected by small versus big market capitalization stocks.