A Tutorial on the Generalized Method of Moments (GMM) in Finance

ABSTRACT Context: empirical problems in which the researcher is faced with a model that is partially specified. In these cases, the GMM method is the natural alternative for estimating the parameters of interest. Objective: the goal of this paper is to offer a tutorial that allows the researcher to understand both the theory and empirical aspects of the GMM method. Methods: we discuss the GMM concepts, forms of estimation, and limitations associated with the method. As a way of illustrating the method, we use two applications in the area of empirical finance. The first application is the estimation of the parameters of a consumption-based asset pricing models; the second is the estimation of the parameters of the evolution of the interest rate in continuous time. The data and codes in R are provided as online appendices. Conclusion: the GMM method can be used in problems where other methods such as maximum likelihood are not feasible, or even when the researcher wants to estimate a model partially specified.