Capturing the Impact of Unobserved Sector‐Wide Shocks on Stock Returns with Panel Data Model

Abstract

Unobserved industry-wide common shocks cause issue of cross-sectional dependence (CSD) in panel data modelling of stock returns. In this study we apply two econometric techniques: SUR approach and a Bayesian estimator for panel data model with factor structural errors, to allow for CSD within a particular industry. By applying these models to monthly stock returns of S&P100 companies from six industries over 10 years, we can capture and measure the heterogeneous impacts of not only observed individual company accounting fundamentals and market-wide common shocks, but also the unobservable industry-wide common shocks.Results from the empirical study show that the impacts from both observed factors and unobserved industry-wide common shocks vary markedly across companies. After controlling observed accounting fundamentals and market-wide common factors, considerable proportions of variations in stock returns can be attributed to unobservable industry-wide common shocks.JEL classification: C11, C13, G12