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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.

Thanks!

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  • $\begingroup$ If I understand it well, then you have $N$ stocks, and within each of these stocks you have observations $(x_{ij}, y_{ij})$, $i=1 \dots N, j=1 \dots n_i$ ? So I would suggest you to use the generalised least squares estimator. An R-implementation can be found in package nlme, function 'gls' where your grouping variable is the stock. You know R ? $\endgroup$ – user83346 Nov 19 '15 at 7:14
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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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  • $\begingroup$ Thanks for your answer. Two follow-up questions please: 1) Do weights need to be normalized in weighted-least squares? 2) What do you think about $w_i = \sqrt{T_i}$ $\endgroup$ – Mayou Dec 5 '14 at 15:12
  • $\begingroup$ No, the weights don't have to be normalized, but it's nice to have them to be equal to 1 when num of obs are equal because then SSE will be the same as in OLS. It's just easier to compare and track the results. Square of $T_i$ is good too, because it links to random walk properties of volatility/time. $\endgroup$ – Aksakal Dec 5 '14 at 15:16
  • $\begingroup$ Great thank you. So in your opinion, what is the difference (advantage) of using $\sqrt{T_i}$ instead of $T_i$ as weights? $\endgroup$ – Mayou Dec 5 '14 at 15:28
  • $\begingroup$ Stocks with larger samples will have less impact than in linear weight $\endgroup$ – Aksakal Nov 11 '16 at 14:34

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