CFA II Quantitative Method

CFA II Quantitative Method

Reading 9 Correlation & Regression
Sample Covariance.
Sample Correlation Coefficient.
Scatter Plot:
1. XY
2. r 1 1

Correlation Analysis Limitation: 3

1. Outlier Impacts or
2. Spurious Correlation
3. Nonlinear relationshipdoesnt capture strong nonlinear relationships.

Hypothesis test on population correlation = 0: two-tailed t-test

=population parameter; two-tailed hypothesis
test statistic sample correlation, r n-2 degrees of freedom

calculated test statistic critical t-value for the appropriate degrees of freedom
level of significance. 3I107

Simple Linear Regression: explain variation in a dependent variable in terms of variation in a

single independent variable.
Variation: degree to which a variable differs from its mean value.

Linear Regression 6 assumptions:

1) dependent independent variable linear relationship.
2) independent variable is uncorrelated with the residuals.
3)expected value of residual term = 0
4) residual terms variance is constant for all observations
5) Residual term is independently distributed the residual for one observation is not correlated
with that of another observation
6)Residual term is normally distributed 3I110

- linear regression model X Y

Yi = ith observation of the dependent variable, Y

Xi = ith observation of the independent variable, X
b0 = regression intercept term
b1= regression slope coefficient
= residual for the ith observation ( disturbance term error term )

Linear Equation --- line of best fit regression line: 3I111

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sum of the squared differences ( vertical distances ) between the Y

values predicted by the regression equation and actual Y-values,Yi, is minimized.- SSE = Sum
of Squared Errors: sum of the squared vertical distances between the estimated and actual
Y-values

simple regression ordinary least squares regression.

the values estimated by the estimated regression equation least squares estimates.

Estimated slope coefficient: 0

variance of X.

Standard Error of Estimate: degree of variability of the actual Y-values relative to the estimated
Y-values standard error of the residual

Coefficient of Determination (R2) : percentage of total variation in dependent variable explained

by independent variable. simple linear regression1 independent variable, R2
correlation coefficient R2= r2. multiple regression

Regression Coefficient Confidence Interval

null hypothesis is H0:b1=0 and the Ha: b1 0. confidence interval at the desired level
of significance 0, the null is rejected. 3I114

tc = critical two-tailed t-value for the selected confidence level with the appropriate number of
degrees of freedom (=n-2 )
==standard error of the regression coefficient, SEE .

Null Hypothesis about a population value of a regression coefficient 3I116

A t-test to test the hypothesis that the true slope coefficient,b1, is equal to some
hypothesized value. Letting be the point estimate for b1, the appropriate test statistic with
n-2 degrees of freedom is:
decision rule for tests of significance of regression coefficients is:

to test whether an independent variable explains the variation in the dependent

variable(i.e., it is statistically significant), the hypothesis that is tested whether the true slop is zero
(b1 = 0).
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estimated regression model dependent predicted

Confidence Intervals for Predicted Values of Dependent Variables.

regression coefficients confidence interval.3I117
tc = two-tailed critical t-value at the desired level of
significance with df=n-2
Sf = standard error of the forecast. 3I117
Sf, Sf 3I118

Analysis of Variance: statistical procedure ; analyze total variability of dependent variable.

Total sum of squares (SST): Sum of squared differences between the

actual Y-values and the mean of Y.
Variance of dependent variable=SST/(n-1)

Regression sum of squares (RSS) measures variation in dependent

variable that is explained by independent variable. Sum of predicted
distances between predicted Y-values and the mean of Y. 3I119

Sum of squared errors (SSE): measures the unexplained variation in the

dependent variable. the sum of squared residuals. Sum of the
squared vertical distances between the actual Y-values & the predicted
(expected ) Y-values on the regression line. 3I119

SST = RSS + SSE

1) k = the number of slope parameters estimated n = the number of observations.

regression df = k error df = (n-k-1) simple regression line ()k=1

F-statistic: how well a set of independent variables(as a group) explains the variation in the
dependent variable.
MSR = mean regression sum of squares
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MSE = mean squared error

one-tailed test !
F-Statistic with One Independent Variable. 3I122
The calculated F-statistic is compared with the critical F-value,
Fc, at the appropriate level of significance. Degrees of freedom
for & with one independent variable
df =k=1;df =n-k-1=n-2 n = number of observations.
Decision rule for the F-test reject H0 if F> Fc --
in simple linear regressionwith one independent variable, F-test
t-test for the slope coefficient tb1. F=

Regression analysis limitations:

1) parameter instability: linear relationship changes over time.
2Regression model
3if any of regression analysis assumptions doesnt hold

Reading 10 Multiple Regression & Issues in Regression Analysis

Multiple Regression

Estimate regression equation: 3I138

t-statistic has n-k-1 degrees of freedom.

k is the number of regression
coefficients in the regression. 3I140
Determine Statistical Significance: 3I141
The most common hypothesis test on regression
coefficient:test null hypothesis that the
coefficient is zero versus the alternative that it is not:
Interpret P-Value: 3I142
P-value: smallest significance level for which the null hypothesis can be rejected. Coefficient
hypothesis test to compare the p-value to significance level:
1) P-value < significance level, the null hypothesis can be rejected.
2) P-value > significance level, the null hypothesis can not be rejected.
other tests for Regression Coefficients 3I143
H0:coefficient = 3; Ha: coefficient 3 two tails
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H0: coefficient > 5; Ha: coefficient 5 ( one tail )

one tail test two tails t-statistic> critical
valuereject t-statistic< critical valuereject

Confidence Intervals for a Regression Coefficient simple linear regression. 3I144

The critical value is a two-tailed value with n-k-1 degrees of freedom where n is the number of
observations & k is the number of independent variables.
- confidence interval t-test with a null hypothesis of equal to zero statistical
significance of the regression coefficient 145

Multiple Regression Model Assumptions simple linear regression.

1) dependent independent variables linear relationship.
2) independent variables not random exact linear relation between two or more
independent variables.
3) expected value of the error terms, conditional on the independent variable, is zero
4) Errors terms variance is constant for all observations.
5) Error terms for one observation is not correlated with that of another observation.
6) error terms is normally distributed. 3I146

F-statistic simple linear regression

1. Whether at least one independent variable is significant to dependent variable
2. H0 : b1=b2=b3=b4=0 vs Ha: at least one bj 0
3. test all of the coefficients simultaneously F-test

Coefficient of Determination, R2
percentage of variation in the dependent
variable is collectively explained by all
of the independent variables.
R = correlation between actual values of y & forecasted values of y

Adjusted R2, R2, R2 <0

Dummy Variable: 1. binary in nature (either on or off , 1 0).

2. distinguish between n class, n-1 dummy variables.
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4.The intercept terms b0 the average value of EPS

for . omitted class as reference point.
5. multiple regression, F statistic R2
6. 1 /2 /3 EPS 4 t-test on b1/b2/b3 ( n-k-1 degree of freedom)
Multiple Regression 3
Heteroskedasticity assumption the variance of the residuals is constant
across observations== residual (error) variance squared residual(error)
independent variable value
1unconditional heteroskedasticity & 2Conditional heteroskedasticityC.H.
coefficient standard errors( or ) coefficient - t statistic F test
1) scatter plot of residual 2) Breusch-Pagan chi-test: one tailed test
: (a)R2 regression
(b) one-tailed test
heteroskedasticity R BP test statistic
2

1) robust standard errorswhite-corrected standard errors

heteroskedasticity-consistent standard errors.
2) generalized least squares modify original equation

Serial Correlation ( auto correlation) :

assumptions residual terms are correlated with one another. Time series data
1).Positive Serial Correlation regression error R.E.
2).Negative Serial Correlation regression error R.E.
PSC coefficient standard errors coefficient - t statistic
MSE F test
1. scatter plot of residual
2. Durbin Watson statistic:

sample size

r = correlation coefficient between residuals from one period and those from the previous period.

degree of freedom k with upper and lower critical DW-values (du dl)
1) DW test statistic =2, error terms are homoskedastic & not serially
correlated.
2) DW < 2, error terms are positive S.C. (r>0)
3) DW > 2, error terms are negative S.C. (r<0) 3I164
Heteroskedasticity
1. Adjust coefficient standard errors: Hansen method (Hansen-white standard errors)
2. Improve model specification.

Multicollinearity (independent variable)

Two or more independent variables linear combination of independent variables are highly
correlated (with each others.)

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coefficient standard errors coefficient ()- t statistic

t test F test t test none of individual coefficient is significant while F

test shows significance2
1 2 correlation >0.7 multi
2 2 individual linear combination multicollinearity.
omit one or more independent variablesstepwise regressionsystematically remove
from regression until multicollinearity is minimized.

When we change model specification, regression parameters change. 3I167

Model misspecification: 3 3I168

1. functional form can be misspecified:
1)important variables are omitted. 3I170 2)variables should be transformed.
3) data is improperly pooled.
2. Explanatory variables are correlated with the error terms in time series model:
1) a lagged dependent variable independent variable
2) a function of dependent variable independent variable
3) independent variables are measured with error.
3. other time series misspecification nonstationarity

Model specification biased & inconsistent regression

coefficient hypothesis test
Consistent Estimator: sample size standard error of
sample mean accuracy of parameter estimate

Qualitative Dependent Variable models: 1) probit & logit model

2) discriminant models
( dummy variable)

Regression Estimation economic meaning slope

coefficient> expected change in Yi for one unit change in Xi

Reading 11 Time-Series Analysis

Time Series

Linear Trend Model:

Ordinary least squares regression

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Log-linear trend modelfinancial time seriesexponential growth

Positive exponential growthdata plot convex curve
Negative exponential growth data plot concave curve

Linear Trend Model

Log-linear Trend model3I191

Trend Models Limitation 3I192

Serial Correlationresiduals log-linear model.
Durbin Watson statistic. DW=2 r=0 (residual correlated), log-linear
model. DW 2 residual terms correlated

Autoregressive Model: dependent variable is

regressed against one or more lagged values of itself.

Covariance stationary: a time seriess mean, variance, covariance with lagged & leading values do
not change over time. AR model 3 1constant & finite expected value 2)
constant & finite variance 3) constant & finite covariance between values at any given lag.

Autoregressive model with order P:

P number of lagged values that the autoregressive model will include as independent variables.
Chain rule of forecasting: one-step ahead forecast for AP model two-step
ahead forecast.

AR(1)model observation 40 n=39,

AR(2)model 2 observation. 40
observation
40 additional prior data.

Serial correlation AR model best model for time series

AR model is correctly specified> t testdurbin Watson statistic
1. Estimate the AR model using linear regression: start with a first-order AR model [i.e.
AR(1)] using
2. Calculate the autocorrelations of models residual
3. Test the autocorrelations are significantly different from zero.

Mean reversion:

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all covariance stationary time series finite mean-reverting level.

lag coefficient <1 an AR(1) time series will have a
finite mean-reverting level. 3I196

Root mean squared error: accuracy of AR models in forecasting out-of-sample values:

3I197

Random Walk: 3 best forecast

1) Expected value of each error is zero
2) Variance of error terms is constant
3) No serial correlation in error terms.

Random Walk with a Drift: intercept 0.

b0 = the constant drift; b1 = 1

finite mean-reverting level time series covariance stationaryexhibits unit root

(b1=1), least squares regression AR model.
Unit root test for nonstationarity:
1)AR model correctly specified
2)Dickey Fuller test: AR (1)model Xt-1,
whether new transformed coefficient (b1-1) is significantly
different from 0 using modified t-test.

First Differencing: time series has unit root (random walk), transform data into a covariance
stationary time series - Dickey Fuller test. finite mean-reverting level =
0-model the change in dependent variable

Seasonality: patterns that tend to repeat from year to year. 1)model misspecification 2) residual
autocorrelation seasonality
Correcting for seasonality - additional lag of dependent variable () is added as
additional independent variable. Xt, Xt-4.

Autoregressive Conditional Heteroskedasticity: variance of residual in one period is dependent on

the variance of residual in a previous period.
ARCH(1) regression model
coefficient a1 is statistically different from zero, the time series is ARCH(1). 3I207
generalized least squares. 3I207
ARCH model time series residual variance

Two time series:

1. covariance stationary, linear regression coefficient
2. covariance stationary, linear regression
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3. covariance stationary co-integrated, linear regression

4. covariance stationary co-integrated, linear regression
Co-integration: two time series are economically linked
(related to same marco variables) or follow the same trend.
two time series co-integrated, regressions error
terms covariance stationaryt-test
Residuals Dickey-Fuller Engle-Granger test unit root, reject unit root, error terms
covariance stationary two time series co-integrated.

Time Series AR model unit root b1 finite mean reverting level

-model covariance stationary-model AR model

Structural change: run two different models shift

Reading 12 Probabilistic Approaches: Scenario Analysis, Decision Trees, and Simulations

Steps in simulation:
1. Define probabilistic variables
2. Determine probability distribution of these variables: specify a distribution 3
1historical data 2) cross-sectional data 3) pick a distribution & estimate parameters
3. check for correlations among variables: strong correlations, 2 1 allow one to vary
(highest impact on valuation) 2 build the rules of correlations into
simulations
4. run the simulation

Simulation 1better input quality 2) provide a distribution of expected values rather

than a point estimate

3 constraints
1.book value constraints:
1)regulatory capital requirement:banks & insurance companies. 2) negative equity: capital
2.earnings & cash flow constraints
3.market value constraints: minimize the likelihood of financial distress.

Simulation limitations:
1. Input quality: rubbish in, rubbish out
2. Inappropriate statistical distribution
3. Non-stationary distribution:
4. Dynamic correlations

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Risk adjusted value:

Cash flows from simulation risk adjusted discount rate asset risk adjusted value.
asset risk in discount rate double count such risk.

Scenario Analysis, decision tree simulation

Scenario analysis & decision tree discrete risk. Simulation: continuous risk
Scenario analysis: a finite set of scenarios (best/worst/most likely case),
combined probabilities < 1
Decision tree: sequential & sum of probabilities = 1
Simulation & Scenario analysis accommodate correlated variables. decision tree NOT

Simulation decision tree sum of probabilities = 1

complement substitute risk
adjusted valuation. Scenario analysis sum of probability < 1, complement.
1) substitute discounted at risk-free rate value variability
2) complement risk adjusted discounted rate, value variability.
tool double count risk. adjust discount rate for risk apply a
penalty for value variability.

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