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Alternative Methods to Deal with Measurement Error

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Abstract

This chapter discusses how errors-in-variables problems affect estimators in the regression model. In addition, we show alternative methods to deal with measurement error of estimation regression coefficient. These alternative methods include the classical estimation method, the constrained classical method, the grouping method, the instrumental variable method, the maximum likelihood method, the LISREL and MIMIC methods, and the Bayesian approach. Examples using these alternative methods in finance research are also discussed.

This chapter is an update and extension of the paper by Chen et al. (2015).

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Notes

  1. 1.

    For the measurement problems related to the determinants of the capital structure, please see Titman and Wessels (1988), Chang et al. (2009), and Yang et al. (2010). For the measurement problems related to the investment function, please see Erickson and Whited (2000, 2002) and Almeida et al. (2010).

  2. 2.

    Stapleton (1978) further develops MIMIC with more latent variables.

  3. 3.

    Roll (1969, 1977), and Lee and Jen (1978) show that the observed market rate returns in terms of stock market index are measured with errors since the stock market index does not include all assets which investors can invest. Lee and Jen (1978) have theoretically shown how beta estimate and Jensen performance measures can be affected by both constant and random measurement errors of Rm and Rf. Diacogiannis and Feldman (2013), Green (1986), Roll and Ross (1994), and Gibbons and Ferson (1985) have argued that market portfolio measure with errors is an inefficient portfolio and show how the inefficient benchmark can affect theoretical CAPM derivation. Diacogiannis and Feldman (2013) provide a pricing model that uses inefficient benchmarks, a two beta model, one induced by the benchmark, and one adjusting for its inefficiency.

  4. 4.

    Empirical work in testing association between the investment decision and cash flow shows that cash flow has poor explanation in determining investment decision. In addition to cash flow, output, sales, and internal funds have significant explanation in determining investment decision.

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Authors and Affiliations

  1. Department of Finance and Economics, Rutgers Business School, Rutgers University, Piscataway, NJ, USA

    Cheng-Few Lee

  2. Department of Finance, National Chengchi University, Taipei, Taiwan

    Hong-Yi Chen

  3. Center for PBBEF Research, Morris Plains, NJ, USA

    John Lee

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Lee, CF., Chen, HY., Lee, J. (2019). Alternative Methods to Deal with Measurement Error. In: Financial Econometrics, Mathematics and Statistics. Springer, New York, NY. https://doi.org/10.1007/978-1-4939-9429-8_7

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