Solved – Determine weights in weighted least squares regression

generalized-least-squaresleast squaresregressionweighted-regression

Assume we have a cross-section of $N$ stocks. $Y_i$ is an sample variance estimate of stock returns for stock $i$. This sample variance is estimated using $T_i$ number of observations. All $T_i$ are not necessarily equal, i.e. the sample size for $Y$ estimation differ for i = 1,2,.., N.

Now I want to run a cross-sectional weighted least squares regression:

$Y_i = \beta X_i + \epsilon_i$

What is the best choice of weights here, such that the weights are based on $T_i$ for each $Y_i$. In other words, I want to assign a smaller weight to stock $i$ if $T_i$ is small.

Best Answer

I don't think there's a single optimal weight scheme here. I'd try first $w_i=\frac{NT_i}{\sum_iT_i}$. This way $\sum_iw_i=N$ and if $T_i=T_j\to w_i=1$, nice qualities.

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