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Journal of Financial Econometrics Advance Access originally published online on March 8, 2007
Journal of Financial Econometrics 2007 5(3):491-522; doi:10.1093/jjfinec/nbm006
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Copyright © The Author 2007. Published by Oxford University Press.

Estimating Cointegrated Panels with Common Factors and the Forward Rate Unbiasedness Hypothesis

Joakim Westerlund
     Lund University

Address correspondence to Joakim Westerlund, Department of Economics, Lund University, P.O. Box 7082, S-220 07 Lund, Sweden, or e-mail: joakim.westerlund{at}nek.lu.se


  Abstract

This article proposes a bias-adjusted estimator for use in cointegrated panel regressions when the errors are cross-sectionally correlated through an unknown common factor structure. The asymptotic distribution of the new estimator is derived and is examined in small samples using Monte Carlo simulations. For the estimation of the number of factors, several information-based criteria are considered. The simulation results suggest that the new estimator performs well in comparison to existing ones. In our empirical application, we provide new evidence suggesting that the forward rate unbiasedness hypothesis cannot be rejected.

KEYWORDS: panel cointegration, information criteria, common factor model, cross-section dependence, forward rate unbiasedness hypothesis

The author would like to thank Rolf Larsson, George Tauchen, an associate editor and two anonymous referees for many helpful comments and suggestions. Financial support from the Jan Wallander and Tom Hedelius Foundation, research grant number W2006-0068:1, is also gratefully acknowledged.

Received August 3, 2006; revised January 8, 2007; accepted January 30, 2007


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