AppliedMultiple choice
Two nearly identical factors · Part 2 of 3
You regress a stock’s returns on two standardised factors whose sample correlation is 0.95. Both factors genuinely matter.
You add a ridge penalty. What does it do to the two coefficients?
- AIt shrinks both by the same proportion, like scaling the OLS estimate down
- BIt sets the weaker coefficient exactly to zero
- CIt barely changes their sum but heavily shrinks their difference
- DIt removes the collinearity bias, leaving both coefficients unbiased
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