Quantitative Finance, 2009, 1–13, iFirst

Robust estimation with flexible parametric

distributions: estimation of
utility stock betas
JAMES B. MCDONALDy, RICHARD A. MICHELFELDER*z and
PANAYIOTIS THEODOSSIOUzx
yDepartment of Economics, Brigham Young University, Provo, UT, USA
zSchool of Business–Camden, Rutgers University, 227 Penn Street, Camden, NJ 08102, USA
xCyprus University of Technology, Cyprus
Downloaded By: [informa internal users] At: 16:48 4 February 2010

(Received 26 June 2006; in final form 16 January 2009)

The distributions of stock returns and capital asset pricing model (CAPM) regression residuals
are typically characterized by skewness and kurtosis. We apply four flexible probability
density functions (pdfs) to model possible skewness and kurtosis in estimating the parameters
of the CAPM and compare the corresponding estimates with ordinary least squares (OLS) and
other symmetric distribution estimates. Estimation using the flexible pdfs provides more
efficient results than OLS when the errors are non-normal and similar results when the errors
are normal. Large estimation differences correspond to clear departures from normality. Our
results show that OLS is not the best estimator of betas using this type of data. Our results
suggest that the use of OLS CAPM betas may lead to erroneous estimates of the cost of capital
for public utility stocks.

Keywords: Robust estimation; Beta; Flexible distributions; Skewness; Kurtosis

1. Introduction and purpose Harrington (1980) conducted two surveys on the use
of the CAPM for utility regulation and found that the
Consistent with the well-established literature on the model had either been considered or was being used by
characteristics of the distributions of stock returns in 38 utility commissions. Cooley (1981) reviewed the use
general, public utilities’ stock returns distributions have of the CAPM in estimating the cost of equity capital for
thick tails (leptokurtosis) as well as skewness. Estimating public utility companies and concluded that its use
capital asset pricing model (CAPM) betas using ordinary ‘‘has not been merely nominal’’. In a review of surveys,
least squares (OLS) when the data (returns and regression Cooley (1981) found that the Federal Communications
errors) are non-normal results in inefficient estimators. Commission and a minimum of 20 state utility commis-
Inefficient betas are prone to greater estimation error sions had heard testimony involving the application of the
as their distributions have larger dispersion. They are CAPM. Out of 54 jurisdictions surveyed in 1978, 16 rate
more likely to be insignificant due to larger standard cases involve the use of the CAPM, and there were 12 more
errors. The major focus of this study is efficient robust the following year. A web search of the use of the CAPM in
estimation with application to the CAPM for public public utility rate cases today will easily demonstrate its
utilities. Its main motivation stems from the fact that widespread application. Bey (1983) found that the out-
public utility regulators and utilities, in addition to comes of public utility rate cases had a tremendous impact
investors and stock analysts, regularly use CAPM betas on financial health of both the consumers and the utility
to estimate the cost of common equity for public utilities. companies. He concluded that the CAPM should be used
in such cases in the best possible manner.
Investor-owned public utilities are price and rate-
*Corresponding author. Email: richmich@camden.rutgers.edu of-return regulated. Estimating the cost of common equity
Quantitative Finance
ISSN 1469–7688 print/ISSN 1469–7696 online  2009 Taylor & Francis
http://www.informaworld.com
DOI: 10.1080/14697680902814241
 2 J. B. Mcdonald et al.
for setting the regulated utility’s allowed rate of return with
inefficiently estimated betas results in larger errors in the
pricing of electricity, and therefore creates inequitable shifts
of wealth between the regulated firms and consumers.
Moreover, more precise cost of capital estimates result in
less uncertainty in the regulatory electricity price setting
process and capital investment. In a risk-averse world, more
precise cost of capital estimates will have a significant
positive impact on the societal economic welfare. From the
investor’s point of view, more accurate estimates of cost of
capital and portfolio inputs in general will lead to the
construction of more efficient portfolios. Siegal and
Woodgate (2007) and Klein and Bawa (1976) discuss the
impact of estimation error on the optimal portfolio choice
and performance.
The major sources of beta estimates to investors,
utilities and regulators come from investor information
services such as those provided by Value Line, Merrill
Lynch and Goldman Sachs. These beta estimates are
mainly based on the OLS estimation method and as such
Downloaded By: [informa internal users] At: 16:48 4 February 2010
they are likely to possess larger estimation error. In this
paper, we show that the use of flexible pdfs in regression
estimation leads to betas which are more efficient
in that they may possess smaller variances than those
associated with OLS. We evaluate the effectiveness
of several ‘flexible’ parametric probability distributions
for estimating more efficient betas with quasi-maximum
likelihood estimation and compare them with OLS
and the generalized method of moments (GMM). These
pdfs include the skewed generalized T (SGT), the skewed
generalized error distribution (SGED), the skewed expo-
nential generalized beta of the second kind (SEGB2)
and the inverse hyperbolic sine distribution (IHS).
The first three pdfs have been developed in the last 10
years. The IHS was first introduced in 1949 but has
remained obscure until the recent interest in robust
estimation and addressing non-normality in regression.
The flexible pdfs accommodate wide ranges of skewness
and kurtosis and therefore may result in more efficient
estimated betas when the data are non-normally dis-
tributed. Although the applications herein involve electric
utility stocks, the estimation methods universally apply
to all types of company stock CAPM parameters as their
stock returns pdfs typically have thick tails and skewness.
Thus, we suggest that the application of inefficient betas
may be a source of general equity market mis-pricing
and inefficiency as stock returns and their regression
errors are typically non-normal.
2. Empirical distributions of stock returns
Mandlebrot (1963) and Fama (1965) initially established
that the distribution of stock returns regression residuals
have leptokurtosis. McDonald and Nelson (1989) and
Harvey and Siddique (1999) found skewness and thick
tails in tests of various stock indices and asset classes.
Harvey and Siddique (2000) found positive skewness and
co-skewness with the stock market for portfolios of
electric and water utility stocks, in addition to other
stock portfolios. Chan and Lakonishok (1992) concluded
that since the distribution of stock returns is non-normal
for so many studies due to kurtosis that OLS estimators
of beta will often be inefficient. They found substantial
efficiency gains using robust methods when returns
contain extreme outliers.
Efficient beta estimation addressing skewness or
kurtosis is also discussed by Fielitz and Smith (1972),
Francis (1975), McDonald and Nelson (1989), and Butler
et al. (1990). Theodossiou (1998) rejected the assumption
of normality of returns for multiple stock exchanges
indices, exchange rates, and gold. Akgiray and Booth
(1988, 1991) considered a mixture of normal distributions
and non-normal empirical pdfs in modeling the statistical
property of exchange rates. Bali (2003) fits alternative
pdfs (non-normal) to model the extreme changes in the
US Treasury securities market. Bali and Weinbaum
(2007) also reject the normality of stock market returns
for various indices. The literature concluding that asset
returns pdfs have skewness and kurtosis and therefore are
non-normal pdfs is vast. Generally, stock and other asset
returns pdfs have fat tails due to extreme outliers and
are often asymmetric. OLS estimators are highly sensitive
to extreme values. Electric utility as well as non-utility
stock returns have pdfs that are thick-tailed and skewed.
In these cases, alternatives to OLS can yield more efficient
estimators.
3. Flexible probability distributions
and robust estimation
There are a myriad of robust estimation methods.
Although many are discussed in this paper, some methods
such as those of Yohai and Zamar (1997) and Martin and
Simin (2003) are not, as this paper focuses on those
methods that reflect generality in pdf by accommodating
varying levels of skewness and kurtosis and that nest
many pdfs. Martin and Simin (2003), however, do find
some interesting results with the data-dependent weighted
least squares approach that they developed and tested.
Boyer et al. (2003) differentiate ‘robust,’ or outlier-
resistant estimators, into reweighted least squares (RLS)
or least median squares (LMS) and partially adaptive
estimators. Partially adaptive estimation procedures can
be viewed as being quasi-maximum likelihood estimators
(QMLE) because they maximize a log-likelihood function
corresponding to an approximating error distribution
over both regression and distributional parameters. RLS
and LMS address only the explicit choice of regression
parameters. Therefore the pdfs in this investigation are
referred to as flexible pdfs. Boyer et al. (2003) use Monte
Carlo simulations to test the efficiency of flexible pdfs,
RLS and LMS. Using one of the four flexible pdfs and
a more restrictive version of another pdf used in this
paper, they concluded that flexible pdfs were found to
produce more efficient estimators than outlier-resistant
methods that do not accommodate changes in pdf
 Robust estimation with flexible parametric distributions
parameters when regression models have skewness or
kurtosis. Therefore, among the myriad of robust estima-
tion methods, this paper focuses on flexible pdfs.
The flexible probability distributions considered in this
investigation can accommodate a wider range of data
characteristics than commonly used distributions such as
the normal, log-normal, Laplace, and T. Although the
Laplace is a pdf and least absolute deviations (LAD) is an
estimation method, they produce the same estimates,
analogous to the normal pdf and OLS. The flexible
probability distributions are the SGT from Theodossiou
(1998), the SGED from Theodossiou (2001), the SEGB2
from McDonald and Xu (1995), and the IHS from
Johnson (1949). These distributions have been used by
Hansen et al. (2007) to model various financial time series
with skewed and leptokurtic distributions such as various
stock market index returns, exchange rates, and the price
of gold. The SEGB2 and the more restrictive, non-skewed
version of the SGT, the generalized T (GT), were used by
Boyer et al. (2003).
Downloaded By: [informa internal users] At: 16:48 4 February 2010
These distributions nest several well-known distribu-
tions often used in econometric modeling. Some of the
distributions that are nested in the flexible pdfs include:
the normal, T, skewed T (ST) (Hansen 1994), GT
(McDonald and Newey 1988), generalized error (GED)
(Box and Tiao 1962), Laplace, and uniform distributions.
See Appendix A.
4. Estimation of alphas and betas
The CAPM is formulated below in equation (1). This
version assumes that the intercept, , is equal to zero. A
number of empirical tests of the CAPM structure have
tested  as evidence against the CAPM structure. Handa
et al. (1993) simultaneously test  as a vector of ’s for
a series of stocks within portfolios and find evidence that
’s are non-zero with monthly returns data. Other studies
such as Black et al. (1972), Blume and Friend (1973), and
Fama and MacBeth (1974) perform empirical CAPM
tests by estimating the security market line and perform-
ing tests on the intercept and whether the slope is equal to
the market risk premium.
The estimation of the CAPM alpha and beta
parameters for each utility company stock return is
accomplished by estimating the following model via
maximization of the sample log-likelihood function of
equation (2):
ðRi,t  Rf,t Þ ¼ i þ i ðRm,t  Rf,t Þ þ "i,t ,
( )
X
T
max lði , i , i, j ji Þ ¼ max ln fi, j ð"i,t ji, j Þ ,
i ,i ,i, j i ,i ,i, j
t¼1
where j ¼ SGT, SGED, SEGB2, IHS, Laplace, T, GED,
GT, ST, and Normal, "i,t is the error of the stock return-
generating process for utility stock i (i ¼ 1, 2, . . . , 36),
t denotes the time period (t ¼ 1, 2, . . . , T ), Ri,t is the stock
return of utility i for period t, Rm,t is the stock market
3
return, Rf,t is the risk-free rate of return, i and i are the
alpha and beta for utility stock i, i is a vector of
distributional parameters in the pdf j, and i includes the
data for estimation. GMM is also applied as it requires no
prior assumption on the pdf of the error term. A complete
discussion of the special estimation methods and the
flexible pdfs is presented in appendix A.
5. Estimation results
The sample consists of 36 electric and electric and gas
combination companies that were continuously publicly
traded between January 1990 and December 2004. These
include all publicly traded companies with SICs 4911
and 4931. Any stock that stopped trading and did not
have continuous returns during the period was removed
from the sample. This exclusion involved only one utility
stock.
Market and utility stock returns are monthly total
stock returns that are obtained from the University of
Chicago’s Center for Research in Security Prices (CRSP)
database. The market is defined by the CRSP value-
weighted index that includes all stocks traded on the
NYSE, NASDAQ, and the AMEX. We used monthly
data to be generally consistent with practitioners’ use of
monthly data for estimation. Monthly data resulted in
180 stock return observations for each utility stock and
the market. The risk-free rate is the one-month return on
the one-month US Treasury Bill. The excess market
return is the same as defined in the Fama–French
database.
A review of the descriptive statistics of the excess
returns data for the utility stocks (mean, standard
deviation, skewness, excess kurtosis, Jarque–Bera (JB)
statistic) was performed for the 36 utility stocks for the
entire period January 1990 to December 2004. The mean
monthly excess return (in decimal format) is 0.0057 and
its standard deviation of 0.0631 results in an average
return-to-risk, or Sharpe ratio of 0.09. This is a typical
reward-to-risk ratio for stocks. By comparison, the
20-year US Treasury Bond average Sharpe ratio is 0.06
between 1961 and 2002. The mean excess kurtosis and
skewness values are 2.832 and 0.0941, respectively.
The JB statistics show that almost all of the utility stocks’
returns distributions are non-normal. The JB statistic
is asymptotically 2 distributed with two degrees of
freedom and has a critical value of 5.99 at the 5% level of
significance. This test shows that the levels of skewness
ð1Þ and excess kurtosis of the returns distributions lead
to the conclusion that the returns are non-normally distri-
buted for 28 of the 36 companies. Rather than testing
ð2Þ the significance of skewness and kurtosis independently,
we reviewed their joint test with the normal pdf and
no excess kurtosis nor skewness as the null hypothesis.
Table 1 displays the beta estimates for each of the
alternative estimators. It also includes the GMM estima-
tor since GMM requires no prior distributional assump-
tion for the error term. GMM parameter estimates are
 Downloaded By: [informa internal users] At: 16:48 4 February 2010

Table 1. Beta estimates from alternative pdfs.

Company OLS GMM LAD T GED GT SGED SEGB2 IHS ST SGT Median Max 

GMP 0.0119 0.1091 0.1445 0.1558 0.1689 0.1457 0.1087 0.1298 0.1624 0.1657 0.1661 0.1457 0.1779
AEP 0.2270 0.1943 0.3439 0.3387 0.3142 0.3417 0.3154 0.3298 0.3345 0.3350 0.3337 0.3337 0.1074
CMS 0.7755 0.6240 0.6454 0.5691 0.6781 0.5220 0.6767 0.6282 0.5771 0.5635 0.4492 0.6240 0.0988
PGN 0.2416 0.1941 0.2684 0.2570 0.2544 0.2545 0.3092 0.2887 0.2831 0.2945 0.3092 0.2684 0.0676
CIN 0.1028 0.1095 0.2035 0.2043 0.2062 0.2063 0.1776 0.1765 0.2167 0.2153 0.1775 0.2035 0.1139
ED 0.0881 0.0896 0.1113 0.1306 0.1156 0.1156 0.1157 0.1354 0.1354 0.1336 0.1157 0.1157 0.0473
DPL 0.3864 0.3488 0.3746 0.3861 0.3714 0.3721 0.3812 0.3741 0.3840 0.3835 0.3789 0.3789 0.0024
DTE 0.1139 0.0805 0.1751 0.1139 0.1059 0.1059 0.0959 0.1073 0.1068 0.1091 0.0959 0.1068 0.0067
D 0.2024 0.1417 0.1936 0.1810 0.1859 0.1810 0.1407 0.1626 0.1607 0.1605 0.1547 0.1626 0.0398
DUK 0.2917 0.1950 0.2657 0.2472 0.2657 0.2657 0.2542 0.2535 0.2542 0.2439 0.2542 0.2542 0.0375
EDE 0.1588 0.1733 0.1084 0.1577 0.1307 0.1579 0.1613 0.1526 0.1552 0.1569 0.1578 0.1577 0.0025
FPL 0.1847 0.2261 0.3439 0.3482 0.3439 0.3470 0.3470 0.3255 0.3448 0.3469 0.3446 0.3446 0.1623
HE 0.2112 0.2124 0.2435 0.2240 0.2202 0.2237 0.2267 0.2202 0.2206 0.2272 0.2276 0.2237 0.0164
IDA 0.3587 0.3201 0.3647 0.4203 0.4023 0.3705 0.4002 0.4149 0.4184 0.4175 0.3779 0.4002 0.0597
WR 0.4956 0.4741 0.4879 0.5341 0.4869 0.5370 0.5083 0.5074 0.5329 0.5257 0.5083 0.5083 0.0372
ETR 0.1453 0.1457 0.3943 0.2713 0.2919 0.2316 0.3325 0.2822 0.2851 0.2815 0.2434 0.2815 0.1872
NI 0.2644 0.2319 0.2232 0.2755 0.2293 0.2809 0.2598 0.2604 0.2590 0.2414 0.2503 0.2590 0.0040
SRP 0.5977 0.4847 0.5795 0.4747 0.7370 0.4773 0.6847 0.5474 0.4998 0.4825 0.4851 0.4998 0.0870
NU 0.3946 0.3531 0.3177 0.3596 0.3183 0.3183 0.3283 0.3273 0.3554 0.3607 0.3283 0.3283 0.0392
OGE 0.1877 0.2392 0.1772 0.2118 0.2145 0.2150 0.2128 0.2169 0.2103 0.2068 0.2128 0.2128 0.0292
PCG 0.3023 0.2967 0.2890 0.3173 0.2901 0.2890 0.2901 0.2872 0.3097 0.3184 0.2901 0.2901 0.0074
PPL 0.4221 0.4097 0.4696 0.4024 0.4722 0.4207 0.4377 0.4413 0.4190 0.4117 0.4292 0.4221 0.0191
PNW 0.3913 0.3526 0.3062 0.3623 0.3062 0.3318 0.4121 0.3493 0.3739 0.3797 0.3598 0.3598 0.0208
POM 0.2614 0.3155 0.3381 0.2377 0.2636 0.2605 0.2768 0.2393 0.2377 0.2380 0.2605 0.2605 0.0154
PNM 0.5966 0.6286 0.5914 0.6428 0.6175 0.6175 0.6358 0.6473 0.6478 0.6483 0.6358 0.6358 0.0513
J. B. Mcdonald et al.

PEG 0.2758 0.4898 0.4596 0.5190 0.5395 0.5254 0.5035 0.4967 0.5282 0.5247 0.5035 0.5053 0.2524
PSD 0.2174 0.2443 0.2483 0.2566 0.2433 0.2433 0.2418 0.2424 0.2568 0.2538 0.2418 0.2433 0.0394
EIX 0.2423 0.3246 0.3778 0.4118 0.4087 0.4107 0.4068 0.3737 0.4112 0.4143 0.4087 0.4087 0.1689
SCG 0.2254 0.2013 0.2883 0.2949 0.2787 0.2787 0.2329 0.2705 0.2971 0.2931 0.2329 0.2787 0.0717
SO 0.0005 0.0235 0.0379 0.0057 0.0152 0.0110 0.0139 0.0014 0.0020 0.0057 0.0116 0.0014 0.0134
TE 0.2465 0.2073 0.3159 0.2607 0.2991 0.2991 0.2727 0.2817 0.2618 0.2522 0.2727 0.2727 0.0352
TXU 0.0517 0.0607 0.1917 0.1194 0.1950 0.1209 0.0285 0.1650 0.1433 0.1376 0.1455 0.1376 0.2167
UIL 0.3749 0.3350 0.2761 0.3355 0.2868 0.3080 0.3142 0.3124 0.3311 0.3414 0.3142 0.3142 0.0438
UTL 0.4000 0.3318 0.2983 0.3185 0.2990 0.2990 0.3081 0.3040 0.3134 0.3194 0.3081 0.3081 0.0866
WEC 0.1097 0.0538 0.2805 0.2128 0.2004 0.2127 0.2144 0.2264 0.2235 0.2207 0.2226 0.2144 0.1167
WPS 0.0992 0.0968 0.1369 0.1111 0.1163 0.1163 0.1211 0.1101 0.1094 0.1077 0.1211 0.1111 0.0219
Minimum 0.0517 0.0235 0.0379 0.0057 0.0152 0.0110 0.0139 0.0014 0.0020 0.0057 0.0116 0.0517 0.2524
Median 0.2420 0.2290 0.2886 0.2734 0.2828 0.2798 0.2834 0.2820 0.2841 0.2873 0.2666 0.2820 0.0322
Maximum 0.7755 0.6286 0.6454 0.6428 0.7370 0.6175 0.6847 0.6473 0.6478 0.6483 0.6358 0.6473 0.0988
Mean 0.2647 0.2576 0.3020 0.2961 0.3020 0.2893 0.2985 0.2941 0.2988 0.2974 0.2869 0.2961 0.0496
Std Dev. 0.1755 0.1551 0.1386 0.1419 0.1594 0.1362 0.1642 0.1457 0.1433 0.1423 0.1334 0.1433 0.0825

Max  is the maximum difference between the OLS and the flexible pdf betas (SGT, SEGB2, IHS, SGED).
 Robust estimation with flexible parametric distributions 5

asymptotically consistent despite the non-normality of
the error term.y Generally, the betas are similar in
magnitude across the various pdf estimates. The medians
of the GMM estimates are a little less than obtained using
other methods. The maximum GMM estimate is less than
the maximum of all other methods except for one stock.
However, it is common across the stocks for the OLS
(and GMM) estimate(s) to have the largest difference
from the other estimates, which may agree quite closely.
There does not seem to be any systematic under- or
under-estimation of the beta by OLS compared with the
flexible pdfs. We also did not observe any of the robust
estimators to have a tendency to be more or less similar to
OLS. The case of GMP is an example of a large difference
with the OLS estimate being 0.012 and the flexible pdf
estimates ranging between 0.109 and 0.167. CIN has
an OLS beta of 0.103 and a range of flexible pdf betas
ranging between 0.177 and 0.217. These two stocks’ betas
are substantially different from the OLS estimates.
The resulting risk premia, i(Rm,t  Rft), to estimate
Downloaded By: [informa internal users] At: 16:48 4 February 2010
Although not presented, none of the alpha estimates
are statistically significantly different from zero. This is
consistent with the structure of the CAPM when using the
excess-return CAPM equation for empirical testing, given
that, according to theory, alpha should be equal to zero.
A comparison of the log-likelihood values corresponding
to the estimates for 11 regression error distributions
(not presented for brevity), including the four flexible
pdfs and their symmetric counterparts, normal or OLS,
the Laplace or LAD, T, and ST show that the log-
likelihood estimates are generally higher for the more
flexible distributions. The OLS results are associated with
the smallest log-likelihood value, which follows from
the normal being a special or limiting case of many of the
other pdfs being considered and due to its inability to
fit thick tails and skewness. Furthermore, in each case
(SGT, ST, SGED, SEGB2, and IHS) the more general pdf
is seen to provide a statistically significant improvement
relative to the normal for almost every stock using
a likelihood ratio (LR) test.

their costs of equity of capital and allowed rates of
return would differ by the same magnitude. Although
most of the OLS beta differences are not so dramatic, they
have the largest systematic difference from the other
estimates. The mean of the maximum difference between
the OLS and flexible pdfs’ betas is 0.0496. Given that
the value-weighted portfolio beta for the utility stocks is
0.21, this is a substantial difference, and would lead to
a large difference in the estimated cost of capital for the
portfolio. It appears that the agreement among the robust
estimators on the estimate of betas indicates that these
methods are controlling for the impact of large unduly
influential data points.
An inspection of electric utility company betas in Value
Line from the March–May 2004 issues that include
electric utilities have a mean adjusted beta (Blume 1975)
a ¼ 0.33 þ 0.67u of 0.79 and unadjusted Value Line
mean beta of 0.69. Value Line uses OLS to estimate raw
betas then applies the Blume beta adjustment shown
above. To the extent that OLS is used to estimate betas to
compute estimates of the public utilities’ cost of common
equity capital and allowed (regulated) rates of return on
invested capital, the degree of the difference between OLS
and flexible pdf betas due to possible larger estimation
error should be an important regulatory policy question,
as well as a statistical problem. Note that utility betas are
adjusted by Value Line with the above Blume equation
that assumes that they converge to one, whereas in reality
they do not.
Table 2 reports values of the LR test statistic
corresponding to testing the hypothesis that the estimated
distributions of the regression errors are observationally
equivalent to the normal. This statistic is asymptotically
distributed as 2 with degrees of freedom equal to the
difference in the number of distributional parameters
when the normal is nested in the estimated pdf as in the
case of the SGED. The 2 is not appropriate for non-
nested pdfs. The LAD does not nest the normal and
therefore the test does not appear for that pdf.
The asymptotic distribution of LR is not 2 distributed
for ‘limiting’ cases where the parameter is on the
boundary of the parameter space such as when comparing
a T with a normal pdf. While the excess returns are non-
normally distributed as shown from JB tests, we would
not be surprised if the errors behave similarly as found by
Blume (1968).
However, simulations conducted by McDonald and Xu
(1992) suggest that the statistical differences will be at
least as large as those based on the use of a chi-square
distribution.z Most of the reported LR values imply the
rejection of the normality assumption at the 5% level.
The exceptions are ED, DTE, HE, PGN, WPS, and WEC
stock returns. The tests for these stocks indicate that the
alternative pdf regression is not a better fit than the
normal. These stocks also have JB statistics for excess
returns that do not reject the null hypothesis that they are
normally distributed. PSD and PNM have some insignif-
icant chi-square statistics among the alternative pdfs.

yWe used the fully iterative GMM estimator as developed by Newey (1988). We used OLS estimates to provide the starting values
for the iterative process, which we allowed to iterate until ‘convergence’ was achieved. We used J ¼ 4 moment conditions in defining
the objective function to be optimized, thus the convergence involved simultaneously minimizing the correlation between functions
of the first four moments of the estimated error with the independent variable as outlined by Newey (1988).
zBased on simulations of 1000 replications, the size of the LR test associated with estimating various pdfs which nest the normal,
exponential, or lognormal distribution was explored. When the nested distribution corresponded to a special case of the estimated
pdf, the size of the LR test was close to that predicted by the ‘asymptotic Chi-square distribution’. However, in the case where the
nested distribution corresponded to a limiting case of the estimated distribution that violated a regularity condition, the size of the
LR test appeared to be less than suggested by the ‘asymptotic Chi-square’ for large sample sizes. This simulation included the GED,
T, GT, and SEGB2, but not the SGT or IHS. This suggests that the statistical significance of the limiting cases in table 2 are even
greater than might be inferred from the ‘Chi-square’ values.
 Downloaded By: [informa internal users] At: 16:48 4 February 2010

Table 2. Log likelihood ratio test for pdfs v. Normal pdf.

Company T GED EGB GT SGED SEGB IHS ST SGT

GMP 63.86 64.23 59.67 65.24 68.62 62.78 66.00 64.79 68.13
AEP 9.71 7.80 9.54 10.10 7.81 9.57 9.76 9.75 10.15
CMS 67.55 60.24 58.41 68.68 61.03 58.52 67.38 67.57 69.25
PGN 1.50 2.11 1.70 2.11 4.67 2.33 2.16 2.73 4.67
CIN 9.97 12.60 12.07 12.60 14.54 14.15 10.64 10.34 14.54
ED 1.77 2.44 1.77 2.44 2.68 2.09 2.07 1.91 2.68
DPL 14.26 15.45 15.47 15.59 16.04 15.79 14.88 14.33 16.05
DTE 0.00 0.18 0.01 0.18 0.65 0.53 0.54 0.35 0.65
D 12.15 12.77 13.62 13.00 14.24 15.18 14.33 13.96 14.59
DUK 20.91 25.40 25.32 25.40 25.60 25.54 22.63 21.23 25.60
EDE 20.99 17.30 19.86 21.08 18.35 19.87 20.86 21.17 21.20
FPL 24.89 24.06 24.34 25.16 24.15 24.50 25.31 24.98 25.24
HE 1.64 1.47 1.61 1.66 2.07 2.52 2.47 2.07 2.12
IDA 10.86 6.45 9.77 14.67 6.52 9.78 10.49 11.28 14.98
WR 27.16 26.96 27.40 27.31 29.74 29.53 28.11 27.45 29.74
ETR 12.77 9.57 12.15 13.67 10.23 12.89 13.30 13.32 14.23
NI 31.49 26.07 28.67 32.52 26.39 28.92 31.31 32.07 32.97
SRP 72.50 67.57 64.78 72.50 67.38 64.86 73.12 73.03 73.03
NU 11.51 16.18 15.92 16.18 16.60 16.36 12.44 11.57 16.60
OGE 8.24 8.76 8.89 8.85 11.09 10.27 9.89 9.40 11.09
PCG 44.66 45.75 43.98 45.79 45.76 43.98 45.62 44.66 45.81
PPL 36.33 35.63 35.90 36.86 38.12 38.08 38.72 37.63 38.62
PNW 33.41 32.98 33.37 34.17 33.30 33.74 34.11 33.63 34.55
POM 14.51 10.57 13.42 18.23 11.02 13.67 14.34 14.62 18.23
PNM 4.76 6.28 5.92 6.28 9.77 9.82 9.31 8.50 9.77
J. B. Mcdonald et al.

PEG 36.02 35.59 35.56 36.81 39.59 38.63 39.51 37.92 39.60
PSD 4.80 9.40 8.08 9.40 9.42 8.12 5.65 5.14 9.42
EIX 46.02 46.50 45.10 47.32 46.62 45.14 47.22 46.03 47.42
SCG 11.70 14.83 14.39 14.83 15.22 14.79 12.65 11.77 15.22
SO 6.10 6.68 6.42 6.71 6.74 6.46 6.28 6.10 6.74
TE 8.48 10.25 10.27 10.25 11.48 10.59 9.31 8.84 11.48
TXU 72.25 66.49 65.20 72.25 66.25 66.26 73.43 74.86 75.02
UIL 12.30 12.29 12.81 12.43 14.69 13.65 13.07 13.18 14.69
UTL 12.31 15.82 15.40 15.82 15.96 15.53 12.93 12.33 15.96
WEC 6.36 6.32 6.66 6.55 6.46 6.87 6.75 6.63 6.78
WPS 1.79 2.60 1.93 2.60 4.87 4.17 4.10 3.58 4.87
Minimum 0.00 0.18 0.01 0.18 0.65 0.53 0.54 0.35 0.65
Median 12.31 13.80 14.01 15.21 14.96 14.99 13.19 13.25 15.59
Maximum 72.50 67.57 65.20 72.50 68.62 66.26 73.43 74.86 75.02
Mean 21.54 21.27 21.26 22.92 22.32 22.10 22.52 22.19 23.94
Std Dev. 20.95 19.59 18.76 20.69 19.67 18.85 21.03 21.03 20.84

The ratios approximate the 2 distribution with the degrees of freedom equal to the difference in the number of parameters compared to the normal pdf. The pdf’s with the largest number of parameters is 5 and the
normal has 2, so the greatest degrees of freedom is 3. The critical value at a 5% level of significance is 7.81.
 Robust estimation with flexible parametric distributions 7

These stocks excess returns also have relatively higher simulations that compare the efficiency of betas estimated
(than the stocks listed above) but insignificant JB with OLS and the flexible pdfs when the error term is
statistics. normally distributed, is mixed normally distributed
The relative impacts of skewness and kurtosis are tested (varying variances and therefore has thick tails), and is
to determine if departures from normal data and the asymmetric (has skewness).
resulting inefficiency in beta estimates are generated
more dominantly from skewness or kurtosis. Skewness
is important to understand as negative or positive skew-
6. Simulations and estimator performance
ness may be an indicator of adverse or favorable (from
the shareholder’s perspective) regulation. See Brigham
McDonald and White (1993) and Boyer et al. (2003) used
and Crum (1978).y The SGT, ST, SGED, and SEGB2
Monte Carlo methods to compare the relative efficiency
regressions were estimated along with their symmetric
of several regression estimators. Some of the estimators
counterparts (GT, T, GED, EGB2) of these pdfs by
considered included OLS, LAD, a normal kernel esti-
constraining the skewness parameters to the values that
mator (Manski 1984), GMM (Newey 1988), and partially
represent no skewness. We have performed LR tests
adaptive maximum likelihood estimators based on the
(not shown) comparing their fits. All but two stocks 2
assumption of the error terms being independently
statistics are insignificant. None of the SGT-GT and ST-T
and identically distributed as GT, GED, or SEGB2.
LR tests are significant and only 2.8% (one stock) of the
36 stocks LRs for the SEGB2-EGB2 and the SGED-GED The actual error distributions considered included the
are significant. Therefore, kurtosis appears to be the (1) normal, (2) a thick-tailed variance-contaminated
normal (normal mixture), and (3) a skewed log-normal.z
Downloaded By: [informa internal users] At: 16:48 4 February 2010

dominant non-normality parameter affecting the utility

stock regression fits.
The empirical testing leads to the conclusion that
the SGT, IHS, and SEGB2 yield similar results in the
presence of kurtosis and skewness, which can differ
significantly from OLS. Additionally, since partially
adaptive estimation based on SGT includes the LAD,
OLS, and Lk (minimizes (sum of estimated errors)k; see
appendix A) estimators as special cases, the user may
want to consider SGT estimation. It performs better than
the SGED, T, LAD, and the normal based on LR tests.
It performs similarly to the SEGB2 and the IHS. One
must be careful to consider the loss of efficiency from
over-parameterization in using pdfs such as the SGT as it
is defined by five parameters. Note that likelihood ratio
tests between the SGT, SEGB2, and IHS cannot be
performed as they do not nest one another.
One issue that the empirical estimations do not address
is the performance of the flexible pdfs vis-a-vis OLS when
the CAPM regression errors are normally distributed.
When the errors are independently, identically, distri-
buted (i.i.d.) as normal, then OLS is the minimum
variance of any unbiased estimator. However, if the
errors are i.i.d. as non-normal, OLS is still the minimum
variance linear unbiased estimator, but nonlinear robust
estimators may be unbiased and have a smaller variance
than OLS. The next section involves a series of
Major findings included (1) little efficiency loss for
partially adaptive estimation based on an over-parame-
terization of the distribution of normally distributed
errors; (2) very similar performance of fully iterative
adaptive and partially adaptive estimators in the case of
symmetric thick-tailed distributions;x and (3) clear dom-
inance of the SEGB2 partially adaptive estimator over all
other estimators considered in the case of a skewed error
distribution. Ramirez et al. (2003) used the same sample
design and found that partially adaptive estimation based
on the IHS distribution yields nearly identical results
to the SEGB2 for normal, symmetric thick-tailed, and
skewed error distributions.
The simulations reported in this section are based
on the same error distributions considered in the
papers by Johnson (1949), McDonald and Xu (1995),
and Theodossiou (1998), and use similar data-generating
processes as used by Manski (1984), Newey (1988),
McDonald and White (1993), and Ramirez et al. (2003).
The model simulated in this paper is
yt ¼  þ xt þ ut ¼ 0 þ 0:21xt þ ut , ð3Þ
where the xt’s correspond to the 180 observed monthly
excess returns on the market, the error terms ut have zero
mean and unitary variance, and the scale parameter  is
selected to generate an R2 similar to those obtained from

yThe importance of determining whether non-normality is due to asymmetry or thick tails is important since skewness can result in
biased intercepts (Jensen’s alphas) under specific conditions, as shown by McDonald et al. (2009). This is also an important
estimation issue if using the single index model (Ri ¼ i þ iRm þ "i) to predict stock returns. Note that the T-values of the intercept
for the log-normal pdf in the simulations shown in table 3 are substantially higher for the non-normal symmetric pdfs (LAD, GED,
T, and GT). The LAD and T intercepts are statistically significant, which is an indicator of bias, as the expected value of the estimate
of this parameter is 0. Secondly, negative or positive stock returns skewness can be generated by adverse or favorable regulatory
treatment of utility profits, respectively. Although beyond the scope of this paper, skewness caused by regulatory treatment of
utilities can effect the efficient and unbiased estimation of the models used to estimate the cost of capital.
zAll three error distributions are standardized to have a zero mean and unitary variance. The first error distribution is merely a unit
normal generated by u1 ¼ z, where zN(0,1). The thick-tailed variance contaminated error distribution is generated by
u2 ¼ wz1 þ (1 – w)z2, where z1N(0, 1/9), z2N(0,9), and w is 1 with probability 0.9 and 0, otherwise. This distribution is symmetric
and has a standardized kurtosis of 24.33. The log-normal distribution is generated by u3 ¼ (ez – e0.5)/(e2 – e)0.5 where zN(0, 1). This
distribution has standardized skewness and kurtosis of 6.185 and 113.94, respectively.
xThe fully iterative adaptive kernel and GMM estimators performed much better than the corresponding two-step estimators.
 Downloaded By: [informa internal users] At: 16:48 4 February 2010

Table 3. Simulations of betas, alphas, and predictions of utility stock returns.

Panel 1: Mean of Intercept, Slope and Expected Portfolio Return Based on 10,000 Simulations
A. Intercept
Means OLS LAD SL GED SGED T ST GT SGT IHS SEGB2 GMM
Normal 0.00209 0.00085 0.00292 0.00123 0.00199 0.00169 0.00223 0.00276 0.00270 0.00000 0.00692 0.00976
Mix-Normal 0.00923 0.00476 0.01081 0.00368 0.00653 0.00272 0.00724 0.00338 0.01428 0.00004 0.00005 0.00415
Log-Normal 0.00031 0.90233 0.01266 0.35473 0.13823 0.74909 0.01791 0.52268 0.01709 0.00010 0.00001 0.00682
T-values OLS LAD SL GED SGED T ST GT SGT IHS SEGB2 GMM
Normal 0.00627 0.00200 0.00850 0.00363 0.00594 0.00500 0.00669 0.00807 0.00799 0.00037 0.14521 0.29347
Mix-Normal 0.02776 0.02741 0.02674 0.02376 0.02597 0.02007 0.02026 0.02490 0.01821 0.01229 0.01423 0.12437
Log-Normal 0.00094 2.60688 0.03768 0.76211 0.36736 2.03484 0.05310 1.10216 0.05088 0.02817 0.00166 0.20631
B. Slope
Means OLS LAD SL GED SGED T ST GT SGT IHS SEGB2 GMM
Normal 0.20989 0.20955 0.20978 0.20969 0.20968 0.21001 0.21000 0.20960 0.20966 0.20946 0.20821 0.20912
Mix-Normal 0.21012 0.21020 0.21027 0.21033 0.21035 0.21033 0.21039 0.21054 0.21067 0.21004 0.20988 0.20995
Log-Normal 0.20989 0.20856 0.20783 0.20920 0.20813 0.20932 0.20791 0.20865 0.20775 0.20776 0.20784 0.20770
T-values OLS LAD SL GED SGED T ST GT SGT IHS SEGB2 GMM
Normal 0.00149 0.00470 0.00225 0.00402 0.00414 0.00007 0.00004 0.00505 0.00433 0.00687 0.02223 0.01053
Mix-Normal 0.00154 0.00471 0.00657 0.00917 0.00965 0.01062 0.01223 0.01741 0.02122 0.00120 0.00344 0.00152
Log-Normal 0.00149 0.01833 0.03585 0.01074 0.03598 0.01032 0.04064 0.02130 0.04274 0.04736 0.04507 0.04197
C. Expected Portfolio Return {E(Ri) ¼ âi0.6}
Means OLS LAD SL GED SGED T ST GT SGT IHS SEGB2 GMM
Normal 0.12593 0.12573 0.12587 0.12581 0.12581 0.12600 0.12600 0.12576 0.12579 0.12568 0.12493 0.12547
Mix-Normal 0.12607 0.12612 0.12616 0.12620 0.12621 0.12620 0.12623 0.12633 0.12640 0.12602 0.12593 0.12597
Log-Normal 0.12593 0.12513 0.12470 0.12552 0.12488 0.12559 0.12475 0.12519 0.12465 0.12466 0.12470 0.12462
T-values OLS LAD SL GED SGED T ST GT SGT IHS SEGB2 GMM
Normal 0.00149 0.00470 0.00225 0.00402 0.00414 0.00007 0.00004 0.00505 0.00433 0.00687 0.02223 0.01053
Mix-Normal 0.00154 0.00471 0.00657 0.00917 0.00965 0.01062 0.01223 0.001741 0.02122 0.00117 0.00344 0.00152
Log-Normal 0.00149 0.01833 0.03585 0.01074 0.03598 0.01032 0.04064 0.02130 0.04274 0.04736 0.4507 0.04197
Panel 2: Relative RMSE of Intercept, Slope and Expected Return Based on 10,000 Simulations
A. Intercept
Rel. RMSE OLS LAD SL GED SGED T ST GT SGT IHS SEGB2 GMM
Normal 1 1.27002 1.03041 1.01245 1.00283 1.01277 1.00183 1.02708 1.01434 1.00060 13.75912 10.24300
J. B. Mcdonald et al.

Mix-Normal 1 0.52175 1.21603 0.46599 0.75553 0.40750 1.07375 0.40792 2.35791 0.85925 0.99242 9.98450
Log-Normal 1 2.89146 1.00557 1.75086 1.19931 2.49718 1.01038 2.11148 1.00585 0.99914 0.99542 9.97450
B. Slope
Rel. RMSE OLS LAD SL GED SGED T ST GT SGT IHS SEGB2 GMM
Normal 1 1.24902 1.24482 1.00895 1.01498 1.01022 1.01892 1.02316 1.03356 1.01190 1.04990 1.08530
Mix-Normal 1 0.52606 0.51844 0.46097 0.46008 0.39866 0.40137 0.39696 0.39912 0.42594 0.45086 0.42132
Log-Normal 1 1.03000 0.79201 0.97401 0.67903 0.86121 0.67182 0.82807 0.69019 0.61389 0.62184 0.70882
C. Expected Portfolio Return
Rel. RMSE OLS LAD SL GED SGED T ST GT SGT IHS SEGB2 GMM
Normal 1 1.24902 1.24482 1.00895 1.01498 1.01022 1.01892 1.02316 1.03356 1.01990 1.04990 1.08530
Mix-Normal 1 0.52606 0.51844 0.46097 0.46008 0.39866 0.40137 0.39696 0.39912 0.42594 0.45086 0.42132
Log-Normal 1 1.03000 0.79201 0.97401 0.67903 0.86121 0.67182 0.82807 0.69019 0.61389 0.62184 0.70882

RRMSE is the relative RMSE ¼ RMSE (pdf)/RMSE (normal). RMSE is calculated as follows:
vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
u
u 1 X N  2 X
1 10,000
RMSEðÞ ¼ t i   þ ð  0:21Þ2 ,  ¼ i :
10, 000 i¼1 10, 000 i¼1
œ
The simulated CAPM equations are based on:
   
Ri,t  Rf,t ¼ 0 þ 0:21 Rm,t  Rf,t þ "i ,

where 0.21 is the market-value weighted portfolio beta for the utility stocks.
 Robust estimation with flexible parametric distributions 9

the regressions discussed in section 4. Appendix B
derives the standard error for scaling the error term in
equation (3) for the simulations. The selected value for
beta is 0.21, which is the market-value weighted OLS
beta for the portfolio of utility stocks. The selected value
of alpha is 0. This is based on the insignificance of the
estimates for the stocks. Ten thousand replications
were performed using the methods of OLS, LAD,
skewed Laplace (SL), GED, SGED, T, ST, GT, SGT,
IHS, SEGB2 and GMM estimators. These results extend
those reported by McDonald and White (1993) to include
the SGT, SGED, and IHS partially adaptive regression
estimators of the slope.
Table 3, Panel 1, presents the mean of the intercept,
slope and expected portfolio return and their T-values
based on 10,000 simulations. T-values for the intercept,
slope and expected portfolio return test for bias; the
expected value for the estimated parameter values of
the intercept and slope are 0 and 0.21, respectively.
The expected value for the T-value is 0. The error
Downloaded By: [informa internal users] At: 16:48 4 February 2010
slope estimation since the distribution of the slope will
have greater dispersion with higher mean squared errors.
The LAD and SL are the only slope estimators that result
in substantial efficiency losses when the error term is
normally distributed. However, this is not unexpected
since the LAD distribution is the only pdf considered that
does not nest the normal pdf. For the thick-tailed and
symmetric errors distribution, OLS provides the largest
slope RMSE of any of the estimators considered. All of
the estimators except for LAD and SL yield similar
RMSEs with a thick-tailed symmetric error term. In the
case of skewed and thick-tailed error distributions, OLS is
again the worst performing slope estimator. It is in this
case that the partially adaptive estimators (ST, SGT, IHS,
SGED, and SEGB2) give evidence of the potential of
significant increased efficiency for the slope relative to
OLS. GMM also performs well given that it is an
estimator that is pdf independent.
The simulations of the portfolio of utility stocks
expected returns were performed to determine which of

distributions considered are the normal, thick-tailed
contaminated normal, and the skewed log-normal.
Panel 2 contains the slope and expected portfolio returns
relative (compared with OLS) root mean square errors
(RRMSEs). Intercept RRMSEs are not presented for
brevity (they are available upon request). The expected
portfolio returns are simulated and also reported in
table 3 to test the relative pricing performance of the
CAPM with the various estimators. We predicted the
excess portfolio returns to assess those pdfs that generate
the least forecast error. The RRMSEs of the returns are
indicators of forecast error.
The results for the intercept show that it is not
significantly different from 0 and therefore is unbiased
except when the error pdf is skewed and a symmetric
density was applied. Note that the LAD and T pdfs
estimate biased intercepts when the error term pdf is
skewed since their T-values are significantly different
from zero. The T-value for the GT is somewhat high.
Skewness generates intercept bias with the opposite
algebraic sign as all of the symmetric densities yield
intercepts with negative signs yet the log-normal is
positively skewed (see footnote 3). The RRMSEs show
that the efficiency of the intercept estimators of the
flexible pdfs is generally better than the remaining
estimators with skewed errors. The results for the slope
indicate no bias. Their values are close to 0.21 and all of
the T-values are insignificant.y All models, symmetric and
non-symmetric, appear to correspond to unbiased esti-
mators of the slope coefficient. Unbiased estimates of the
slope do not mean that there will not be cost of capital
estimation errors since, on average, the slope will tend
toward its true value. Inefficiency leads to larger errors in
the estimators produces the lowest asset pricing errors.
Simulations of the expected value of the portfolio return
were performed with an assumed zero intercept and the
simulated slopes multiplied by 0.6, which is the expected
value of the market excess return for the sample period.
As expected, the predicted portfolio returns are unbiased
as shown by their values and their T-values. The efficiency
of the expected portfolio return is of interest since higher
efficiency is an indicator of lower returns prediction and
pricing errors. The portfolio returns simulations reflect
estimation risk, since the variance in the simulated error
term reflects the estimation risk associated with estimated
slopes to fit thick-tailed or skewed errors. The results
clearly show that when the error term is thick-tailed or
skewed, the flexible pdfs and GMM have lower RRMSEs
and therefore lower pricing errors. This result essentially
shows that the flexible estimators and GMM are the most
reliable estimators of beta and produce the least pricing
errors.
The inefficiency of the OLS beta estimators can be
visualized as a probability distribution of OLS betas with
greater dispersion than a distribution of betas estimated
by robust methods. This will be reflected in higher
errors in beta estimation, and resulting predictions of
the cost of capital. Envision two beta distributions, one
that is generated from OLS and the other from the IHS
pdf estimates of beta. Although not shown (available
upon request), the beta RMSE for OLS is 0.07645 and
for the IHS the value is 0.04745. All of the four flexible
pdfs (SGT, EBG2, IHS, SGED) have lower RMSEs than
the others and OLS, with an average of about 0.05, but
the IHS is slightly lower than the others. If a beta estimate
from each CAPM beta distribution is chosen at the

yA T-test was used to compare the sample mean of beta from the 10,000 simulation estimates with the hypothesized value of 0.21.
The RMSE was used as the standard error of the sample mean for the T-test. If the sample mean was significantly different than
0.21, there was a bias in the sample mean estimate. A beta equal to 0.21, alpha equal to 0, a desired R2 of 0.04, 180 randomly
generated observations, and a standard deviation of 2.1468 for x are the parametric assumptions based on averages of empirical
results. The corresponding value of  can be calculated, which is multiplied times the ‘standardized’ error terms (u has a mean of 0
and variance of 1 using the standard normal, scaled mixture of normals, and scaled and shifted log-normal variable).
 10 J. B. Mcdonald et al.
same point, such as one RMSE below the expected value
of 0.21, the OLS value is 0.134 and for IHS the value is
0.163. This would lead to 22% greater under-estimation
of the cost of capital risk premium from OLS due to lower
efficiency. The economic impact of such an allowed rate
of return on the public utility required by regulators
would be a windfall in consumer surplus to customers, an
adverse impact on the financial viability of the public
utilities, resulting in a reduction in economic welfare.
Statistically, this may generate negative skewness in the
public utilities stock returns as discussed by Brigham and
Crum (1978).
We recommend that the final choice of slope and
intercept estimator is one of the flexible pdfs if thick tails
and/or asymmetry is present. If there are concerns about
over-parameterization (reduction in efficiency from esti-
mating unnecessary pdf parameters), we recommend the
use of the SGT, IHS, or SEGB2 with testing for statistical
improvements relative to special case pdfs, and then use
the simplest model that is observationally equivalent to
Downloaded By: [informa internal users] At: 16:48 4 February 2010
the most general formulation which allows for possible
skewness and/kurtosis. GMM is almost as efficient an
estimator of the beta as the flexible pdfs if the flexible pdf
estimators are not readily computable.
7. Summary and conclusions
We apply several flexible pdfs for estimating the betas of
public utility company stocks. Estimation methods based
on the flexible pdfs for the error distributions in regression
models, or partially adaptive estimators, were tested
against OLS, other estimation methods involving the
choice of pdf, and GMM. Partially adaptive estimators
were found to be the most efficient of those considered in
the presence of skewed and fat-tailed distributions.
The recommended partially adaptive estimator is based
on the SGT, SEGB2, or IHS if skewness/kurtosis are
present. GMM, which does not assume a particular pdf,
also performed well with non-normal errors.
OLS estimation is efficient when neither skewness nor
kurtosis exist in the pdf of the data, although the partially
adaptive methods that include the normal as a special case
yield similar results. Similar to other stocks, public utility
stock returns and their CAPM regression errors typically
have kurtosis and many have skewness. Therefore, OLS is
an inefficient estimator of beta. This leads to an inefficient
estimate of the cost of common equity capital and
produces the most prediction and pricing error when
thick tails are present. The magnitude of the error in
estimating the cost of common equity capital and allowed
(regulated) rate of return on utility investment is
proportional to the estimation error in beta. Errors in
setting the utility’s allowed rate of return create dis-
balances in consumer and producer surplus and therefore
losses in social economic welfare, result in inefficient
pricing of utility stocks, and general disequilibrium in
energy and related markets as other fuels and conserva-
tion inefficiently substitute mis-priced electric power.
More generally, our results here also suggest that further
research may demonstrate that the substitution of
statistical methods for OLS may result in more efficient
equity markets. Mean and variance estimation risk
affects the choice of optimal portfolios and portfolio
performance.
In appendix A, we review the main distributional
characteristics associated with the flexible pdfs, the
normal, and many other pdfs that they nest. Partially
adaptive estimation based on these distributions was used
to estimate the CAPM for 36 electric utility stocks.
The motivation for selecting electric utility companies
is due to the unique characteristic of regulated rates of
return that appear to be manifest in their skewed and
leptokurtic stock returns and the role estimated betas
have in calculating the cost of capital and in setting
electric utility rates. Based on LR tests and simulations,
the partially adaptive estimators provided significant
improvements relative to OLS in applications in which
the error distribution is skewed and/or thick-tailed.
The statistical performance of the partially adaptive
estimators was also explored using a Monte Carlo study.
The Monte Carlo design was adapted from one used in
a number of other papers which explores the impact of
thick tails and asymmetry as well as the efficiency loss of
over-fitting in the presence of normally distributed errors.
Our results show that potential exists for significant
improvements in estimation efficiency in the presence of
leptokurtosis or skewness in the data, and the efficiency
loss from over-fitting the error distribution in the
standard normal linear model was modest.
Lastly, portfolio prediction simulations show that the
SGT, SEGB2, and IHS produce the lowest pricing
prediction errors, and the next best performer is GMM.
Future research should consider estimating time-varying
conditional betas using the conditional or intertemporal
CAPM with robust estimators as discussed by Bali (2008).
References
Akgiray, V. and Booth, G.G., Mixed diffusion-jump process
modeling of exchange rate movements. Rev. Econ. Statist.,
1988, 70, 631–637.
Akgiray, V. and Booth, G.G., Modeling the stochastic behavior
of Canadian foreign exchange rates. J. Multinat. Finan.
Mgmt., 1991, 1, 43–72.
Bali, T.G., An extreme value approach to estimating volatility
and value at risk. J. Bus., 2003, 76, 83–108.
Bali, T.G., The intertemporal relation between expected returns
and risk. J. Finan. Econ., 2008, 87, 101–131.
Bali, T.G. and Weinbaum, D., A conditional extreme value
volatility estimator based on high-frequency returns. J. Econ.
Dynam. Control, 2007, 31, 361–397.
Bey, R., Market model stationarity of individual public utilities.
J. Finan. Quant. Anal., 1983, 18, 67–88.
Black, F., Jensen, M. and Scholes, M., The capital asset pricing
model: some empirical tests, In Studies in the Theory of
Capital Markets, edited by M. Jensen, 1972 (New York:
Praeger).
Blume, M., The assessment of portfolio performance. PhD
dissertation, University of Chicago, 1968.
Blume, M., Betas and their regression tendencies. J. Finan.,
1975, 30, 785–795.
 Robust estimation with flexible parametric distributions 11

Blume, M. and Friend, I., A new look at the capital asset pricing
model. J. Finan., 1973, 28, 19–33.
Box, G.E.P. and Tiao, G.C., A further look at robustness via
Bayes theorem. Biometrika, 1962, 49, 419–432.
Boyer, B.H., McDonald, J.B. and Newey, W.K., A comparison
of partially adaptive and reweighted least squares estimation.
Econometr. Rev., 2003, 22, 115–134.
Brigham, E. and Crum, R., Reply to comments on the use of
the CAPM in public utility rate cases. Finan. Mgmt., 1978, 7,
72–76.
Butler, R.J., McDonald, J.B., Nelson, R.D. and White, S.,
Robust and partially adaptive estimation of regression
models. Rev. Econ. Statist., 1990, 72, 321–327.
Chan, L.K.C. and Lakonishok, J., Robust measurement of beta.
J. Finan. Quant. Anal., 1992, 27, 265–282.
Cooley, P., A review of the use of beta in regulatory
proceedings. Finan. Mgmt., 1981, 10, 75–81.
Fama, E., The behavior of stock market movements. J. Bus.,
1965, 38, 1749–1778.
Fama, E. and MacBeth, J.D., Tests of the multiperiod two-
parameter model. J. Finan. Econ., 1974, 1, 43–66.
Fielitz, B.D. and Smith, E.W., Asymmetric distributions
of stock price changes. J. Am. Statist. Assoc., 1972, 67,
813–814.
Downloaded By: [informa internal users] At: 16:48 4 February 2010
McDonald. J.B., Michelfelder, R.A. and Theodossiou, P.,
Robust regression methods and intercept bias: a capital
asset pricing model application. Working Paper, 2009.
Newey, W.K., Adaptive estimation of regression models via
moment restrictions. J. Econometr., 1988, 38, 301–339.
Ramirez, O.A., Misra, S.K. and Nelson, J., Efficient estimation
of agricultural times series models with non-normal depen-
dent variables. Am. J. Agric. Econ., 2003, 85, 1029–1040.
Siegel, A.F. and Woodgate, A., Performance of portfolios
optimized with estimation error. Mgmt. Sci., 2007, 53,
1005–1015.
Theodossiou, P., Financial data and the skewed generalized T
distribution. Mgmt. Sci., 1998, 44, 1650–1661.
Theodossiou, P., Skewness and kurtosis in financial data and the
pricing of options. Mimeo, Rutgers University, 2001.
Value Line Investment Survey, Ratings and Reports, March,
April, and May 2004.
Yohai, V.J. and Zamar, R.H., Optimal locally robust
m-estimates of regression. J. Statist. Plann. Infer., 1997, 64,
309–324.
Appendix A: Special estimation methods and
flexible density functions

Francis, J.C., Skewness and investor’s decisions. J. Finan.

Quant. Anal., 1975, 10, 163–172.
Handa, P., Kothari, S.P. and Wasley, C., Sensitivity of As indicated previously, many well-known distributions
multivariate tests of the capital asset pricing model to the are nested within the four flexible distributions. Thus,
return measurement interval. J. Finan., 1993, 48, 1543–1551. maximization of the above likelihood function gives, in
Hansen, B.E., Autoregressive conditional density estimation.
Int. Econ. Rev., 1994, 35, 705–730. the special cases of OLS,
Hansen, C.J., McDonald, J.B. and Theodossiou, P., Some !
X
T
flexible models for partially adaptive estimators of econo- ði , i ÞOLS ¼ arg min "i,t ,
2
metric models. Economics E-Journal, 2007. i ,i
t¼1
Harrington, D.R., The changing use of the capital asset
pricing model in utility regulation. Publ. Util. Fortnightly, Laplace, the LAD estimator (Koenker and Bassett 1978),
1980, 105, 28–30. !
Harvey, C.R. and Siddique, A., Autogressive conditional X
T
skewness. J. Finan. Quant. Anal., 1999, 34, 465–487. ði , i ÞLAD ¼ arg min j"i,t j ,
i ,i
Harvey, C.R. and Siddique, A., Conditional skewness in asset t¼1
pricing tests. J. Finan., 2000, 55, 1263–1295.
Johnson, N.L., Systems of frequency curves generated by and the GED (for fixed k), the Lk estimator,
methods of translation. Biometrika, 1949, 36, 149–176. !
Klein, R.W. and Bawa, V.S., The effect of estimation risk on X
T

optimal portfolio choice. J.Finan. Econ., 1976, 3, 215–231. ði , i ÞGED ¼ arg min j"i,t j ,
k
i ,i
Koenker, R. and Bassett, G., Asymptotic theory of least t¼1
absolute regression error. J. Am. Statist. Assoc., 1978, 73, for an arbitrary but fixed value of k. The skewed
618–622.
Koenker, R. and Bassett, G., Robust methods in econometrics Laplace (SL), the trimmed regression quantile (Chan
(with discussion). Econometr. Rev., 1982, 1, 213–255. and Lakonishok 1992), and the estimators of Koenker
Mandelbrot, B., The variation of certain speculative prices. and Bassett (1982) are given by
J. Bus., 1963, 36, 394–419.
Manski, C.F., Adaptive estimation of non-linear regression X
T X
T
1
models. Econometr. Rev., 1984, 3, 145–194. min ð"i,t Þ or min j"i,t j,
i ,i
t¼1
i ,i
t¼1
ð1 þ signð"i,t Þ Þ
Martin, R.G. and Simin, T.T., Outlier-resistant estimates of
beta. Finan. Anal. J., 2003, 59, 56–69.
McDonald, J.B. and Nelson, R.T., Alternative beta estimation
where, if ð"i,t Þ ¼ j"i,t j and "i,t  0,
for the market model using partially adaptive estimation. ð"i,t Þ ¼ ð1  Þj"i,t j if "i,t 50 for 0 55 1 or  15 5 1,
Commun. Statist.: Theory Meth., 1989, 18, 4039–4058.
McDonald, J.B. and Newey, W.K., Partially adaptive estima- and are therefore nested within the flexible pdfs.
tion of regression models via the generalized T distribution.
Econometr. Theory, 1988, 4, 428–457.
Therefore, by definition, the flexible pdfs are increasingly
McDonald, J.B. and White, S.B., A comparison of some robust, accommodating of the characteristics of the empirical
adaptive, and partially adaptive estimators of regression distributions of stock returns than typically used pdfs.
models. Econometr. Rev., 1993, 12, 103–124.
McDonald, J.B. and Xu, Y.J., An empirical investigation of the
likelihood ratio test when the boundary condition is violated. Characteristics of the flexible probability
Commun. Statist.: Simul., 1992, 21, 879–892. density functions
McDonald, J.B. and Xu, Y.J., A generalization of the beta
distribution with applications. J. Econometr., 1995, 66, All of the following flexible pdfs nest the normal among
133–152, Errata 1995, 69, 427–428. many other symmetric and asymmetric distributions.
 12 J. B. Mcdonald et al.

They have either four or five parameters that describe where

their shapes in contrast to the normal that has two
parameters (mean and variance distributions) and there- C ¼ k=ð2ð1=kÞÞ,
fore is less flexible. As shown below, they exhibit similar
¼ 2 ASð Þ1 ,
performance in fitting an approximating pdf to data that
 ¼ ð1=kÞ0:5 ð3=kÞ0:5 Sð Þ1 ,
has skewness and kurtosis. The choice of one of the pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
following four is recommended below. Sð Þ ¼ 1 þ 3 2  4A2 2 ,
A ¼ ð2=kÞð1=kÞ0:5 ð3=kÞ,
Skewed generalized T and k controls the peakness of the distribution, 50
The SGT is a five-parameter pdf (mean, standard generates negative skewness, and 40 generates positive
deviation, two kurtosis, and skewness parameters). skewness. The nested distributions, or special cases of the
The  and  parameters generate the conditional means. SGED, are
The SGT pdf is ¼ 0 gives the GED,
k ¼ 1 gives the SL,
fSGT ð"; , , , , k, nÞ k ¼ 1 and ¼ 0 give the Laplace,
 ðnþ1Þ=k k ¼ 2 and ¼ 0 give the normal, and
C jð"=Þ þ
jk k ! 1 and ¼ 0 give the uniform.
¼ ,
 ððn  2Þ=kÞð1 þ signð" þ
ÞÞk k
Skewed exponential generalized beta of the second kind
Downloaded By: [informa internal users] At: 16:48 4 February 2010

where
C ¼ k=ð2ððn  2Þ=kÞ Bð1=k, n=kÞÞ,
1=k
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
Sð Þ ¼ 1 þ 3 2  4A2 2 ,
Þ
 ¼ ðk=ðn  2ÞÞ1=k Bð1=k, n=kÞ0:5 Bð3=k, ðn  2Þ=kÞ0:5 Sð Þ1 ,
Þ Þpþq
A ¼ Bð2=k, ðn  1Þ=kÞBð1=k, n=kÞ0:5 Bð3=k, ðn  2Þ=kÞ0:5 ,
¼ 2 ASð Þ1 , B() is the beta function,  and  are the
¼ ð ð pÞ  ðqÞÞ,
mean and standard deviation of ", k controls the peakness
of the distribution, n controls the thickness of the tails,
50 generate negative skewness, and 40 generates
positive skewness.
The major nested distributions, or special cases of the
SGT, are as follows:
¼ 0 gives the GT of McDonald and Newey (1988) and
Boyer et al. (2003),
k ¼ 2 gives the ST of Hansen (1994),
k ¼ 2 and ¼ 0 give the Student’s T,
n ! 1 gives the SGED of Theodossiou (2001),
n ! 1 and ¼ 0 give the GED of Box and Tiao (1962),
n ! 1 and k ¼ 1 give the skewed Laplace (SLAD),
n ! 1, k ¼ 1 and ¼ 0 give the Laplace,
n ! 1, k ¼ 2 and ¼ 0 give the normal, and
n ! 1, k!1 and ¼ 0 give the uniform.
The SEGB2 is a four-parameter pdf (mean, standard
deviation, and two joint skewness/kurtosis parameters).
The SEGB2 pdf is
eð p=Þðð"=Þþ
fSEGB2 ð"; , , , p, qÞC ,
ð1 þ eð p=Þðð"=Þþ
C ¼ 1=ðBð p, qÞÞ,
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
 ¼ 1= 0 ð pÞ þ 0 ðqÞ,
where p and q are positive scaling constants, B( p, q) is the
beta function, and (z) ¼ d ln (z)/dz is the psi function
and psi-prime; the first derivative of the psi function is
known as the digamma function. A smaller value of
p results in a more leptokurtic pdf, q4p reflects negative
skewness, and q5p reflects positive skewness. When
p ¼ q, the symmetric EGB2 obtains, and when p ¼ q ! 1
the normal distribution obtains.
Inverse hyperbolic sine
The IHS is a four-parameter pdf (mean, standard
deviation, skewness, kurtosis). The pdf is
k
fIHS ð"; ,,, , kÞ ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
Standardized values for regression error skewness 2ð2 þ ð"2 = 2 Þ þ
Þ 2
 2  pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi 2 
and kurtosis in the ranges (1, 1) and (1.8, 1) can be k
exp  ln = þ 2 þ ð"2 = 2 Þ þ
 ð þ lnðÞÞ ,
modeled with the SGT. However, not all combinations of 2
skewness and kurtosis are defined by the SGT.
w ¼ sinhð þ ðz=kÞÞ,
 ¼ 1=w ,
Skewed generalized error 1 2 2 2
w ¼ ð1 þ e4j j þ 2 e2j jk Þ1=2 ð1  ek Þ1=2 ej jþk ,
The SGED is a four-parameter distribution (mean, 2
standard deviation, kurtosis, and skewness). The SGED
¼ w =w ,
pdf is 1 2
w ¼ signð Þ ð1  e2j j Þ ej jþð1=2Þk ,
  2
C j"=ð þ
Þjk
fSGED ð"; , , , , kÞ ¼ exp : where a smaller k results in a more leptokurtic pdf,
 ð1 þ signð" þ
Þ Þk k 50 indicates negative skewness and 40 indicates
 Robust estimation with flexible parametric distributions 13

positive skewness. ¼ 0 gives the symmetric IHS. ¼ 0 Thus, for large n and stationary x, R2 approaches
and k ! 1 give the normal distribution.
2
R2 ¼ 1 
2 varðxÞ þ 2
2 varðxÞ 2
Appendix B: Scaling the standardized error ¼ and 1  R2 ¼ 2 :
term for simulations (r ut ) 2 varðxÞþ 2  varðxÞ þ  2
Therefore,
Given that


SSE=n 1  R2 2
R ¼1
2
,  ¼
2
 varðxÞ:
SST=n R2
for the simple bivariate regression model, Given the variance of the x’s used in the simulation,
a beta equal to 0.21, alpha equal to 0, a desired R2 of 0.04,
 X  X
SST 1 n 1 n ^ 180 randomly generated observations similar to the 180
¼ 2¼
ð yt  yÞ  þ ut  uÞ
ððxt  xÞ  2:
n n t¼1 n t¼1 observations in the empirical estimations, and a standard
deviation of 2.1468 of x are the parametric assumptions
For OLS estimation and the related orthogonality based on the means of the empirical results. The
conditions, SST/n can be rewritten as corresponding value of  can be calculated which is
multiplied by the ‘standardized’ error terms (ui has a mean
 " X n Xn
#
SST 1 of 0 and variance of 1 using the standard normal, scaled
^
Downloaded By: [informa internal users] At: 16:48 4 February 2010

¼  2
 þ
ðxt  xÞ2
ut :
2
mixture of normals, and scaled and shifted log-normal
n n t¼1 t¼1
variables).