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Introductory Econometrics
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Learning Outcomes
In this chapter', you will lrnrtr how to e Derive the OLS foLt.uulae fol cstirllatirlg Pafallletcrs ancl theit'
standard errors
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2.1
Key concepts
The key terms to be able to define and explain from thjs chapter are s financial econometrics c continuously compounded returns o time series o cross-sectional data o panel data o pooled data @ continuous data ls discrete data
regressionisanatten-}pttoexplairrl]lovementsitravar.iablebyrefcretrce to novenents itl one ol tr.tofe other variables To urake this rrlore concrete, dellote the variable whose tnowentents
theregressionsee]<stocxplairrbyr,arrdtl-rcvariablesrviricharettsedto expiain those variations bY lr, r:'. ., rt Hence, in this relatively simple
setup, it wor.rlcl be saicl that Variatiotrs in t variables (the \ s) canse changes in sonte othcr.variabic, r'. lltis chapler rviil be limited to tllc casc whcf(' thc nrodci seei(s to explain changes in oirly olle valiablc r (altllor,rgh tirls
28
Ior
Finance
A bricf
Fr$fixf
y Dependent variable Regressand Effect variable Explained variable
Names for
rs
lndependent variables
Causal variables Explanatory variabtes
r.rsed synonyr-rlously
in this book
(see
box
2.1).
2.2
All
rnd .r are being treated in a con-rpletely symmetrical way. Thus, it is not implicd that changes in.t cause changes in r,, or.indeed that cltanges il.r r.cause changes in.r'. Rather, it is simply stated that there is evidence for a linear relationship beLr,veen the fwo variables, and that movements
t"tsk rettll'lls var-y with thcir levcl of t'uat'ket between stock prlces ,* Measuriug the Iong-terltr l'elatiotlsl-tip
e How
asset
ir
dividends
a\rerage related
Suppose
In regression. the dependenl variable l.r.r and the indcpendenr variare treated very differently. The r, variable is assumed to be random or'stochastic'in some way, i.e. to have a probability distribution. The .r variables are, however, assumed to have fixed ('non-stochastic') values in repeated sanrples.l Regression as a tool is more flexible and more nowerfirl tha n corr'4]31jgp.
able(s) (.ts)
be a relati that a researcher has solDe iciea that there should theory suggt ,iip o.*.." ftvo variables l and \ ' anci that fin:rncial in A sensible first st that an increase tn .t wlll leacl to an increase 'r" associatiot't befween the varial to testing whether there is indeed an of t Suppose that tire otttcoure would be to fornl a scatter plot of them'
plot is figlrre 2.1 positive lill In this case, it appeals that there is an approxirllate ltstt'
2.3
Simple regression
Fol sinrpliciry, suppose for now rhar ir is believed that.r'depends on only one .r variable. Again. this is of course a severely lestricted case, but the case of more explanatory variables n'ill be considered in the next cirapter. Three exanrplcs of the kjnd of relarionship rhar rrray be of inrer-cst include:
rneans that incl'eases in r aLe relationship befween t and -r'which that the relationsirip befween tl: accompanieci by increases in r'' and a straigirt line' It would be poss .on fr. describeci appl'oxilrrately by that appears to fit the data' to ciraw by hand onto the grapl-r a line t' line fittec1 by eye could then be lneasurecl i.'rr.r..p, and slope of the to be labor; sttch a metltod is lil<ely tl-re graph. However, rn practice and inaccut'ate. to what extel'lt this It rvould thet'efore bc of interest to de termine
that can be estilrated lislllg ' tionship can be desct'ibed by an equatioll r'rse the general eqtlatioll for a stllight It ls possible to
fi:red proccclr.rre.
Strictly. the assuntptiotr rhrt the rs are non"srochastic is stroncer issne thit will be discuss(.d jn ntore detaji in chlpter.4.
thrn required. rn
r'=u*i.r
30
Introductory Econometics
for
Finance
A brief
oven'taw
of tltt:
@
a
Even in the generar case where there is more than one expranatory variabre, some determinants of 11 wiil arways in practice be omitted rrom tne moout. rnis ,'ght, t",' example, arise because the number of influences on is too large to place in a )j single model, or because some determinants of y may be unobservable or not measurable. There may be errors in the way that is measured which cannot ) be modelled. There are bound to be random outside influences on that agatn cannot be ;, moderred' For exampre, a terrorist attack, a hurricane or a computer failure courd ail affect financiar asset returns in a way that cannot be captured In a moder and cannot be forecast reliably. Similarly, many researchers would argue that human behaviour has an inherent randomness and unpredictabilityl
eye
.
o
to get the line that best 'fits'the data. The rcsearcher. wourcl the. be seeking to find the values of the pal'aneters or coefficieuts, * a'd lJ, which would place the line as close as possible to all of the data points tal(en together. However, this equation (1, = a + B.r) is an exact one. Assumir1g that this equation is appropriate, ifthe values ofa and had been calculated, B tl.ren given a value of ,r, it would be possibre to deternrine with certai'ty what the value of would be. In'ragine - a moder which says with complete ' certainry what the value of one variable will be given any value of the other! clearly this nrodel is not rearistic. statisticaily, it wourd corr.espond to the case where rhe model fitted rhe data perfectiy- that is, ail of trre data points lay exactly on a straight line. To make the moclel nore realistic, a random disturbance te.n, denoted by,, is added to the equation, thus
of the assunption that r is fi-xecl in repeated samples' model problem becomes one of detern-rining the appropriate the of r' giu"n 1or conditional upon) the observed values
as a resttlt
so-t)
for
indicative resu This 'eye'balling' procedure nray be acceptable if only method' as well as being tedious' is lik nre required, but of course this to flt a line to the dat; to be imprecise. The most con'llrloll method used fonns the wolkho known as ordinary least squares (OLS) This approach in detail in t of ecouonetlic nrodel estimation, and will be discussed and subsequent chaPters' the apProprr Two alternatlve estlmation methods (for deterl-nining p) are ti,e method of tnourents and values of the coefficlents cr anci of the method method of maxinrum likelihood' A generalised versiott of t Hansen (1982), is popular' but beyond the scope moments, due to widely emplol'ed' ' is also book. The nethod of maximum likelihood will be discnssed in detail in chapter 8' of data cont; Suppose now fot' ease of exposition' that the satnple of OLS entails taking each vert only-fiu" observations. The metl'rod it and tilen uriniurtr distance fronl the polnt to the line' squaring the areas of squares (l]ence 'least sqtrares )' as sltt]wi the total sum of the stllll ol figure 2.3. This can be vierved as eqrtivalent to tnininrising linc' the aieas of the squares dlawn fi'ou the points to data poirlt for Tightening up the notation, let r', clenote tl're actllal fitted valrte front the regresston linc t and let ii cienote the
scFr'ation
-l'/=a+F.r,*u,
(2.2)
where the subscript t(= 1, 2,3, ...) denotes the observation number. The disturbance term can capture a number of features (see box 2.2). So how are the appropriate values ofo and p deterrnined? a and I are chosen so that the (verticai) distances from the data points to trre firted lines are minimised (so that the line fits the data as closely as possible). The parameters are thus chosen to minimise colectivery trre (ver.ticar) distances fi'orr the data poinrs to the fitted line. This courd be crone by 'eye-balling' the data and, for each set of variables and .r, oue courcr ' form a scatter plot and draw on a iine that looks as ifit fits the clat;r rvell by hand, as in figur.e 2.2. Note that the ve'ficrri distcrrccs are usually mi'inrsecr r.ather tha, the ho.izontal distances or those taken perpendicular to the line. This arises
JZ
inance
tttodcl
3:i
N4ethod of OLS fitting a line to the data by minimlsing the sum of squared residuals
@il
above
count as
tl-rose below woulcl the line wor'tlcl collllt as pol'itivc valttcs' while in large part caucel each othet negatives. So these clist:rnccs will
tlle stllll of the rlistancc's of the l)oillts above the the lille wet'e the sanre ln tha sunr of thc distrlnces of the poit-rts bclow soltltiott fo| the cstirtra:cd:oeffict:lll case, thel'e rvottltl tlot ue a r'rrlirlue olrsetvatton fittcd line that goes tlttor'rgl'r thc tttcau of tl-rc In fact, any taking the sqllat(" (i,e. i, r)wottlcl sct tllc sttlll Of the ri, to zcro Horvcvet" clltel'the t;tlctrlrtitln :r|e positir clistances cltsufes tilllt:tll rleviatiorls thilt
ancl thet'efot'e do
EEil
Plot of a single observati on, together with the line of best fit, the resrdual and the fitted value
{t,i;l
T.his s.n-r
is.l<'ow'
as
the rcsiriuol
- i,
rcttl' Again' it is the clifference bctween the lninimising l, rri is cquivaletrt to llllllllllr So
or the
su''
Of
Squr'c
selected by nrinin"rising tl Letting d arlcl li deuote the valries ofo alld B fol the fitted line is given t'y i' = d -i. RSS, respectively' the cquation knou'n as a loss functiou Tal Now let L denote tl-re RSS' which is also i'e fron t = I to I' wlrere the sunnlation over all of the obsewatior-rs'
= |,1.r',
,- l
-i,)r
(2
other words, for the given value of .r'of this observation /, i, is the vah.re l which the model would have predicted. Note that a hat (^) over a variable or parameter is used to denote a value estimated by a r'oclei. Finally, let ri, denote the residual, which is the difference between the actual value of and the vaiue firted by the model for this data point * ' i.e, (ti * i,). Tliis is shown for just one observation r in figur.e 2.4. \Mrat is done is to nlinimise the sum of the ni. The reason that the sr,ln.l of the squared distances is minimised rather than, for. exa'rple, finding the sun of ri, that is as close !o zero as possible, is that i' the latter case some poinrs rvill lie above the line while others lie below it. Then, when the sunr to be made as close to zero as possible is for-r'ned, the points
for
q and p' to fincl tlle values of al-tcl L is mirrin-rised with respect to (w l''t ) t? to give the line that is clos' which n-riniurise the resldual sumof sqttares w.r.t. a and p, settirrg tlre fir.st del.ivattl to the data. So L is differentiated squares (OLS) estinlatoi' ls g1\ to zero. A cler-ivation of the orclinary least
estirrrrtors fol' the in the appendix to this chapter' The coefficient and the illterccpt are glven
DY
slt
..,1,
- rt'
\2.4)
a=i-iJ.{
otril'the
1,
i
I
Equatiorls (2.4) and (2'5) stiltc th;tt' givclr vaiues of tltc tr'r'o p:lriltllcl' an,i r,. it is always possible to calculate the Equatiorr (2 4) is lhc crlsiest firltlr d rrntl fl, that best fit thc sct of clrta
scts of obsc':'valtotr
_--- -
, -.
.,
r:
I f | |
lt
JA
A brieJ oveniew
oJ the clossical
Table
2.1
IT'?'rr9il plot of
rf,
return
fund XXX
L7.8
on
rxxx,r
- rfr
Scatter excess returns on fund XXX versus excess returns on the n.rarket Portfolio
'1{}
o o
xl0
* ll
2 3 4 5
39.0
72.8
)a)
1.7.2
23.2 6.9
16.8 't2.3
oo
o
o ttl
to use to calcnlate the slope estintate, but the forrrula can also be written nrole intuitively, as
/1
l5
a(-\-r -.1
)(
\'f
-.\')
12.6)
L(.r/
.\')-
,r. and l divided bv the sample vaLiance of .r. To reiterate, this method of finding the optimurn is known as OLS. It is also worth noting that it is obvious from the equation for t1, that the regression line wiil go through the mean of the observations - i.e, that the point (.i,.y) lies on the regression line.
2,3.7 What
are
and
fi
used for?
posing another questioll lf ' This question is plobably best ausu'ercc1 by 20% higl' tells you that she expects the lnarket to yield a return ",r"lyit r.isk-free rate next yeaf, what would yoll expect the leturn ' than the fund XXX to be?
The exPected value
of
\'
:'-7'74 :
3l'06
Example 2.1 Suppose that some data have been coilected on the excess returns on a XXX'1 rogether with the excess returns on a market index as shown in table 2.1,
(2.7)
ir = -1,14 +
1.64 x 20
Tire fund manager has some intuition that the beta (in the CAPM framework) on this fund is positive, and she therefore wants to find whether there appears to be a relationship between x and y given the data. Again, the first stage could be to form a scatter plot of the fwo variables (figure 2,5). Clearly, there appears to be a positive, approximately linear relationship berween .r and .r,, although there is not much data on which to base this conclusionl Plugging the five observations in to rnake up the formulae given in Q.a) and (2.5) would lead to the estirnates d = -1.74 and
E
Tlrus, fbr a glven expecred marl(et risl< premium an excess over the rj riskiness, ftrnd XXX would be expected to earn the regression beta is :t free rate of approximately 31%' h'r this setup' beta of 1 64' s the CAPM beta, so that fund XXX has an estimated In this case' the residual sun gesting that the fund is rather rislqr' OLS coeffici' t'eaches its minimum value of 30'33 with these
of
iqu"ro
values.
be obvior'rs, it is wolth stating that it is not actvlsir Thns to conduct a regressiot't analysis using only five obsewationsl
Although it
n-ray
resultspresentedherecanbeconsiclereclindicativeandforillustrattot
the techniqr-re only.
Son-re
s:
.i,
= -1.74*
I.64.r,
(2.7)
where .r', is the excess return of the market portfolio over tlte r.isk fi.ee rate (i.e. rnt * tf1, also known as the n?arket risk preniunt.
for regression analysis are given in chapter 4' as saying that The cocfficient estlnlate of 1.64 for 19 is iuterpreted else being cq .r'increases by 1 ul'rit. r'rvrll be expectcci' everythitrg negative' a nse to increase by 1.64 urrits'. Of coLlrse' if i had beell coefficient estilllat{ tvoukl on a\/erage car.ise a fall in r" a, the intelcePt
I
36
A brief ovtn'iew o/
Ir-r
modcl
'
E@il
tl-l
pledlctious 1' A similar- cilt-ttiolt should bc exct'cisccl whetr prodttcing l using vrlr.res of .f that are a long way outside the l'allge ol valuestl and 23% in the satnple. ln cxaltlplc 21, r tal(es valtrcs between 7% Droclel to detet'ntit avnilable clata. So, it would not be rclvisilble to ttse this
thecxpectedcxccsslctuf]lorlthefirrldiftlreexllectcdcxcessfetLlfn(
was expected thc lnarl(et werc, say l%' ot'30"/" or' -5% (i c' the nlat'l<c't
fal
I
).
exarlple,inthecontextofdeter'rrrir-rirrgtl.rerelationslripbehl'eetrr.iskal
return|orUI(eqtrities,thepopulatiorrofit.ttclestwotrldbeaiititrreseri
lntel'preted as the value that wor-rld be tal(en by the dependent variable ' a value of zero.'Units'her.e refer to the units of measurement of .r, and r,,. So, for example, suppose that lj : t.O+, ,r is neasured in per cent and .t' is measured in t}rousands of US dollars. Then it would be said that if .r rises by 1%, .r.will be expected to rise on average by $1.64 thousand (or $1,640). Note rhat changing the scale ofr. or .r' will make no difference to the ovel'all results since the coefficient estimates will change by an off-setting factor to leave the ovelall r.elationsl.rip berween l and .r unchanged (see Gujar.ati, 2003, pp. 1,69-773 for a proofl. Thus, if tl're units of measur.ement of l. were hundreds of clollar.s instead of thousands, and everything else reurains unchanged, the slope coefficient estimate would be 16.4, so that a 1% increase in _r.wouid lead to an increase in r.of $16.4 hundreds (or $1,640) as befor.e. All oti.rer.prop_ erties of the oLS estimator discussed below are also invariant to chanscs ir-r the scalir-rg of the data.
Exchange (LSE) obseryations on ali stocks traded on tl-re Lonclon Stocl< infinitc' whilc a sanrple i: Thc popr.rl.rrtott trtry bc c'irlrcr lirritc ol general' eithel all of I selection of itst s0n1d ittems .fron the ltopulatiott' In
obseryationsfortlreentirepopulatiorrwillrrotbeavai]ab]e,oftheyl].lay
sonanyitrnunrbelthatitiSinfeasibletoworkwitlrtlrer-rr,inwlrichcl
saur' it should be representative of the population of interest' A randon population is equ; is a sarnple in which each individual itelu in the likelytobedrawrr.Thesizeoftlresarrrpleisthenunrbelofobservati( thataleavailable,oltlratitisdecidedtouse,inestinatingther.egress:
equatioll'
2.4.2
functton and ff The data generating process, the population regression sam1le regression f unction functiot't (PR-F) is a description of the mc rela||ot'tsllipI'ch4/eclltJtet,oriah]es'Tlrepoptrlationregressiotlftttrctiot.tts. PRF enrbodics'the t known as tire clata gellel'atillg process (DGP) The valttcs,lfu ;tttd li lttd is cxpt'cs:t'd ls
\'/ =
(Y -1
tiratistlrotrglrttobegenet.atir-rgtlreactua]clataanditr.ept.esentsthe
A word of caution is, however, in or.der concerning the leliability of estinates of the constarlt teilr. Although the strict interpretation r:f the
intelcept is ir-rdeed as stated abovc',
ir-r
practice,
it
thele are no values of.r' close to zero in the san'rple. in such i'stances, estimates of the value of the intercept will be unreliable. For. examplc,
consider' figr.rle 2.6, which demonstrates a situation where no points are close to the r,-axis.
P\t a'ttl
Noteti-ratthL.feisaclistul.balrcetefnlillthiseqrratior-r,sothltevcllll obsetvatiotls oll \ illlt haci at orle's dispos:tl tl-te cutit'e popr-rlation of
*..---.,rrlll
Intraduct1ry
A hrief overtiew of Lhe classtcal ltnror regrcssiott tttodel Taking logarithnrs ofboth sides, applying the laws oflogs and rearran! the right-hand side (RHS)
ln
it would srill in generai not be possible to obtain a perfect fit of the line to the data. In some textbooks, a distinction is clrawn befween the pRF (the underlytng true relationship befrveen ), and r) and the DGp (the
process describing the way
)i corne about),
/, =
In(A
)-l f,ln X, *
rt, :
l';
although in tl-ris book, the nvo ternrs will be r.rsed synonynrously. The sample regression function, SRF, is the relationship that has been estimated using the santple observations, and is often written as
where A anci I ale Par:rllletcrs to bc cstillliitcd. Now lct rr aud -1, : ln X, .\i =
cr '1-
)rt(A)' r', =
{'
p.r,
* rt,
t-,:a*f.r,
(2.10)
Notice that there is no error or resiclual term in (2.10); all this equatior-r
states is rhat given a parricular value of.r, niultiplying it by f and aclcling d will give the model fitred or expected value for r,, denotecl i. It is also possible to rvrite
This is lcnown as all cxponsrllinl r-cg|e.ssion rrrodcl since f vat'ies accoto sotne exponeut (power.) firnction nf X. In fact, wltcn :r fcgl'essloll cL tion is expressed in'clouble logalithruic for"nr" rvhicl-r nlealls that tl-re clcpendent ancl the independent variables are uatut'al logarithms.
I
coefficient estin-lates arc irltcfPfetecl as elasticitics (stlictly, they al'e changes on a logaritl-ruric scale). Thus a coefficient estitll)ate of 1.2 for
-ri=d+lJ.r,*ir,
(2.11)
Equation (2.11) splits the observed value of .\, iltto two cornponents: the fitted vaiue from the model. and a residual term. The SRF is used to infer likely values of the pRF. That is, the estimates & and B are constructed, for the sample of data at hand, but what is really of interest is the true relationship befween .r and r, - in other words, the PRF is r,vhat is really wanted, but all that is ever available is the SRFi However, what can be said is how likely it is, given the figures calculated for d and f, that the corresponding population paraneters take on certain
values.
,li=(1+-+l/r .l/
,p,.,
.lr
in tlre -".,r'_ hirr3ri3lg case, the relationship between.r and y must be __' -__- simnle capable of being expressed diagranratically using a straight line. More specifically, the model must be linear in the parameters (a and p), but it does not necessarily have to be linear in the variables (.t. and r). By ,linear. in the parameters'. it is nreant that rhe parametel.s are not multiplied together, divided, squared, or cubed, etc. Models that are not linear in the variables can often be made to tai(e a linear form by applying a sLritable transformation or rnanipulation. For' example, consider the follorting exponential regression ntodel
f,
In order to use OLS, a model that is linear is required, This means that,
i. Clearly, then' a surprisingly vr arrayofmodelscanbeestinateclusingoLSbynrakingsuitabletrat', nations to tl-re variables. on the otl-rer hand, some nodels are intrin-(
and regressing .r on a constant and
n.on-linear, e.g.
.\i:a+f3-t! *ut
Such nrodels cannot be estimated using oLS, but n-right be estir.Ilable a nou-linear estilration metl-tod (see chapter 8)
t
2.1.4
Estimator or estimate? Estinrators are the fbr-mulae used to calculate tlrc coefficienls - for exi, the expressior.rs given in (2.4) and (2,5) above, rvhile tl'Ie estinratc the other hancl, are the actual nunrcrical values for thc coelficient-s tli,
:,{ \:'r"'
(2.121
40
2.5
estimation
a.umber of other
This section shows how to run a bivariate regression usi'g EViews. Tlie example considers the situation wherc an investor wisires to hc.clge a l<.rDg position in the s&P500 (or its corrstituent stocks) using a sl-ror.t position in firtures contracts. Ir,lany acaden'ric studies assLlure that the objective of iredging is to urinimise the variance of the hedgeci por.tfolio retnnrs. [f this is the case, then the applopriatc hedge |atio (the nunrbeL of units of the futures assct to sell per unit of the spot asset held) will be the slope estimate 1i.e. 111 in a regression whele the clepencient var.iable is a time series of spot returns and the independent variable is a time series
tti.t *itt be clisclrssccl later in the book. r Statistics and Common Sample In the di now click otr Descriptive s1 box that appears, tyPe rspot rfutttles lnd click OK' Sonle sumnlary spot ancl ftlttlrcs arc plcscrlted, as displayed in screenshot tics fo| the and these rle ctttitc sitlrilar itct'oss lhe two scrics, as one would expct
nreaslrLes
@
Sulr-lr'r'larY
statlstlcs
0
B
421
0 407460
0 9071 14 Li Li63B03 -B 647093
0 993048
of fr-rtures returns.2 'fhis regression will be ru' using rhe file 'sandphedge.xls', which contains monthly leturlrs for the s&p500 index (in colur.un 2) and S&p500 futures (in column 3). As described in chapter 1, the first step is to open an appropliately din-rensioned workfile. open EViews ancl click on File/New/trV'orkfiie; choose Dated - regular frequency a'd Monthly fre. quency data. The start date is 2002:OZ and the end date is 2007:07. Tl.rcn imporr the Excel file by clicking Import and Read rext-Lotus-Excel. The data start in 82 and as for the previous exa'rple in chapter 1, the first column contains only dates which rve do not need to read in. In 'Nanres for series or Number if named in file', we can write Spot Futures, The two imported series wiil now appear as objects i' the worl<flle and ca' be verified by checking a couple ofentries at random against the original returns. lt is common in academic research to use continuously conrpounded returrls rather than simple returns. To achieve tl'ris (i.e. to produce continuously compounded returns), click on Genr and irr the ,Enter Equation' dialog box, enter dfutures=100.dlog(futures). The'r click Genr egain and do the saure for the spot series: dspot=100-dlog(spot). Do not folget to Save the worhfile. continue to re-save it at regr-rlar intervals ro cr.rsure that no work is lost! Before pioceedi.g to estimate the regressior, now that we harre i'rported urore than one series, we can exanrine a number of clescr.iptive statistics together and measnres of association befween the series. Fol exaurpie, clrck Quick and Group Statistics. From there Vou will see that it is possible to calculatc the covariances or correlations between ser.ies ancl I
sce e)raptcr 8 for
291442
0 001 27 803
1353659 50
1
1068570
0.004782 30 38530 702 8542
65
37817 3787
65
Excel file. The first step is to transform the levels ofthe two series into percentage
Note that the nurlber ofobservations has reduced fronr 66 for the of the series to 65 when we computed the returns (as one obselati 'lost'in constt'ucting the / - I value of the prices in the returns forr
If you war-rt to save the summary statistics' you lllust natlle thelll by ing Name and then choose a nan're, e g. Descstats The delault na 'group01', wiricir could have also been used, Click OI(' rt \A/e can now proceecl to estirrate the |eglession. TheLe;rre seleral is to select Quick and then Estitnate Equatior do this, irut thc easiest
:l ,contlron srltrplc,\\,ill
use on11,thc Paft oflltc santplc thii is rYailaLrle lirf xll th, lbr t'rch selcctcd, wltcrL'as Incliviclurl santPlc'wjll usc all il'rilable obsctwations sr serics. l:l this crse. the rtrtnrbet of obsen'atiotrs is thc sante fbr botlt intlividual ancl so jdcnfical rcsrrlts uould be obserued fbr both oPtions'
A brief ovcrttew
0J
E@@[il estimation
Equation window
Equdtion specrfrcation Dependent variable follovied by list of regressofs includrng AR[lA and PDL terns, OR an explicit equation like Y=c(1)+c(2)-X.
r7fttf,f{il:rrrEstimation resu|rs Dependent Variable RSPOT hlethod Least Squares Date.08/09/07 Tinre 10 17 Sanrple (adjusted) 20021'103 2007 tll07
fspot c rfutures
Coeflicient Std
Estinration settings
Nlethod:
I
t5 -
sampte, i zoozr,roz
ioozuoz -..1
0363302 0444369 0817569 041S7 c RFUTURES oiiiaoo 0133790 0925781 03581 0 421 203 O 013422 llean dependent var i-rquur.O 3 542992 S D dependent var Adltrsted R-squareo u 002238 , ;;695' Akaike info crrterion 5 400342 S E of regressrorr , criterion 5 467246 Sunr squarec resro , J2.4960 Schtvarz 5 426740 Hannan'Ournn criler -'r i3 5i i i Log likelihood 2 16689 Durbin-Watson stat u 857070 F-statistic Prob(F-statistic) 0 358093
1
l--o-_lfc.^*a
will be presented with a dialog will look like screenshot 2.2.
box, which, when
it
In the 'Equation Specification'window you insert the list ofvariables to be used, with the dependent variabie (l') first, and including a constant (c), so type rspot c rfutures. Note that it would have been possible to wlite this in an equation fornat as rspot = c(1) * c(2)-rfutures, but this is uor-e
cuntbersome.
In the 'Estimation settings'box, the default estimation method is OLS and the defauit sample is the whole sample, and these need not be modi' fied. Click OK and the regression results will appear, as in screenshot 2.3. The parameter estimates for the intercept (d) and slope tBt are 0.36 and 0.12 respectively. Name the regression results returnreg, and it will uow appear as a new object in the 1ist. A large number of other statistics are also presented in the regression output - the purpose and interPretatron of these will be discussed later in this and subsequent chapters. Now estimate a regression for the levels of the series rather than the returns (i.e. run a regression of spot on a constant and flltures) alld examine tl'le paranleter estimates. The return reglession slope paratleter estilnated above measures the optimal hedge r-atio and also ureasurcs
series By contrast' the ' the short run relationship berween the tlvo and futures indices (o parameter tn a regr-ession using the raw spot the futures series) can be interp log of the spot serles and the 1og of beween them' Tl'ris isstte o as nreasuring the long run relationship in chapter 4 For now' iong and short runs will be discr-rssed in detail and enter tl.re variables spot c futures rr Quick/Estimate Equation name the regrer eluation Specification dialog box' click OK' tiren (d) in this regressiot] is results 'levelreg'. The intelcePt estimate can be conside-r'ed i and the slope estrnate (P) is 0'9S' The intercept the long-ternr relatio proxitnate the cost ofcarry, while as expected' fol ftr futures prices is altnost 1:1 - see chapter 7 benveen spot and
discussionoftheestilllationandilrterpretatiolrofthislong.tel.tlrrel.
rvhole wolkfile' ship. Finally, click the Save button to save tl're
2.6
cierivecl allove' togetltet The rlroclel .\'r :.r * pt, * rr, that has been thelssrrtrlptiollsllsteC]beiow,isknownastheIl(]ssicdllirlcrtt.tt'.c'l.t'.sstott
,.
rrt
I |lt
If ]1
* ,Best,- utc;llts that thc OLS lsti,tator. f h.s 'rinintuttt variancc al' ther ti.rc. clrss of linear unbiasccl cstitrlrft.rt's; tltc causs-Markov
Technical notation
lnterpretation
The errors have zero mean The variance of the errors is constant and
pfovesthlltthe()I,Scstj|11:ltofisllcstbyc,xarllitritrgatrarbitt.ary
trittivclilre:rl.r-lnbiascclt,stitlratot.allclsltorvirlgil'lallcaSeSthatit have a vaLiatlcc tto strlallct th;ltl I ltc OI-S cstilllatot.'
r;) =
finite over all values of:, The errors are linearly independent of one another
There is no relationship between the error and corresponding .{ variate
Utlclct.:rssrtttrpliorlsl*4lisfcclirllovc,tltcol-Scstill.}iltofclttbcsl
tohavetlrcclcsir.ablclrt.<l.1lct'ticstlliltitiScotlsistct.tt,rttibiasedatrc
cicnt. Unbilseclness atl<l cfflcicrlcy ltltvc rlt'cady beclt discussed cotrsistencyrsltrlaclditiorllrltlcsir'ablc])fopcfty'Tl-tcscthr.cechat.irctct r,vill tlow be cliscr'tssccl itl tttt'tr'
abovt'
but since r', also depends on r/, it is necessary to be specific about ho"v the rr, are generated. T'he set of assumptions shown in box 2.3 are usually made concerning the rr,s, the unobservable error or distulbance terms. Note that no assumptions are made concerning their observable counterparts, the estimated rnodel's residuals. As long as assumption I holds, assurlption 4 can be equivaler-rtly writtell E(.r,rr,) = 0. Both fonnulations imply that the regressor is orthogoral to (i.e. unrelated to) the error term. An alternative assunption to 4, which is slightly stronger, is that the -rr are noll-stochastic or fixed in lepeated sarnples. This means that there is no sampling variation in.r,. and that its value is determined outside the model. A fifth assurnption is required to make valid inferences about the population paraneters (the actual n and B) from the sample paran'leters (d and 13) estin'rated using a finite anount of data:
(CLRM). Data for'"r, is obsenrable,
2.7.1-
ConsistencY
Tl-re least squares
estitrlrtots 'r rnd 7i arc collsistellt One way to staf for t?) ts algebr.aicallv {br f (with rhe obvious ntodifications made linr Prlll3 7-.r
- ll :' Sl: {)
vd :-
(Pr) that l' is This is a technical way of statirlg that the plobabiliry llxed distallce 6 away fromits true value tel' thausolne albitrary o1 zero as the satlple size tends to infinity' for all positive values
tlrelirnit(i.e.foranilrfinitentttrrbetofobseivatiotrs).theprobabil theestirnatorberngciiffer.erltffolnthetrr.levaltteiszero'Thati
estin'lates
will
(5)u,
toinlirriry.Consistencyist]rr.rsalar:gesarlrple.oIaSyll]ptotlcproperl deri'' assumptions that E(t,rr,) : 0 and E(tr,\ = 0 are sufficient to of the OLS estinator' consistency
2.7.2
2.7
Properties of the OLS estimator If assumptions l-4 hold. then the cstimrtols d, and p detcrminccl by OLS
and
E(d,)
will
have a number of desirable propelties, and ale l<nown as Best Linear' Unbiased Estimators (BLUE). \Mrat does this acronym stand for'?
E(fl)
-l.hus,
ft
1 'Estimatol'' - ri and
arc estinrators of the true value of a and /3 r. 'Linear'' - c! and f ale lineal estilrators - that nreans that the fot'n-tulae for cr and 13 ale linear combinations of the randorn valiables (in this
et on avelage, tl.re estimatecl values for the coefficierrts wili'be Ti-rat is, thel'e is llo systeInatic ovefcstilnatioll of their true valnes.
case, r')
estilllatiolroFthetftlecoe|ficiellts..fopl.ovetlrisalsot.cqrtilesthel tion thrt cov(/r/. \, ) = (). Clc'arly, ttubiaseclness is a stlouger conditio saulples (t'e' cousistcncy, siuce it l-rolcls fol surall as u'ell as lalge
samPlc stzes)
___-
'--
'
-,.
'
I t
2"7.3
Efficiency
An estimator p of a parameter fl is said to be efficient if no other estrmrtor has a smaller variance. Broadly speaking, if the estimator is efficient, it will be minirnising the p.obabiliry that it is a lorg way off from the true value of p. In other words, if the estirnator is 'best', the uncertai'ry associated with estimation will be minimised fol the class of linear un. biased estimators. A technical way to state this would be to say that an efficient estlmator would have a plobabiliry distribution that is nar.r.owly dispersed around the true value.
valnes {or. t5e coe{ficicnts. It t'an bc scctr that they arc a fttnctici the, actual obscr.vrtior.rs on thc cxirlaDatoty varirble, .f, thc saurple 7., ancl anothcf terlr, i. Thc l;rst of thcsc is uD cstitnate of tlie varj of the disturl;;ulce fcl'nt.'l-hc uctual vat-iatrcc or thc disttll'ballcc tcl usualiy detrotc'cl by ol. llow tlttt ittt cstitt.titte of ol bt' obtaillcd?
2.8.7
Esttntating the variance of the error term (o:) Front cler.r.rcr.rtitfy stalistics, the vrr-i;tuce of a t'atrclotl'l valiable ir, is giv, var(tt,)
I',1(rr, )
[:(rr1
)lr
2.8
Assr.tnrptiou
l of thc CLRM was that thc cxpectcd or average value errols is zct'o. Under this rssr"rnlption, l2-22) above t'educes to
var(rr, )
= EIrri]
t
.- _ - \ 'ls.
7'u
'
Unfoltunately (224) is tlot woll<able since rt, is a series of popttl disturbances, which is not observable. Thus the sample counterpart which is ri,, is used
,t=f)-,il Tu'
Brrt this estinator is a biased estimatol of or. An r-rnbiased estilr ,rl, rvould be given by the following equation instead of the previou
, I,i;
'-Tl
.r
(([..;)- ri,)
(2.20)
where
ol
(2'261
sr(r)
.,
/tn;
'
\ 7'-2
s is also known as the standard error of tl'Le regressian oI the stalldald of tl-re estimate. It is sometirnes used as a bload measure of the fit regression equation' Everything else being equal, the smaller this qtr is. tl.re closer is tl're fit of the line to the actual data.
whe'e s is the estimated standard deviation of the residuals (see below). These folnulae are derived rn the appendix to this chapter. It is wolth noting that the standard errors give only a general indication of the likely accllracy of the regression parameters. They clo not shorv how accurate a palticular set of coefficient estirnates is. If the standar.d erfors are small, it shows that the coefficients are likely to be precise on average, not how precise they are for this particulai.sample. Thr.rs standard errors give a measure of the degree 0f u'rcertainty in the estinrated
2.8.2
It is Possible, of course' to
clerive the formulae for the standrl'd of the coefficiellt estinates frorn first plinciples using soure algebt'
Hr-
48
this is left to the appendix to this chapter. Sorne general intuition is n.:-., given as to why the folrnulae for the standar.d eLrors given by (2.20) :rld (2.21) contain the telns that they clo and in the form ttrat they clo. l'ire presentation offered in box 2.4 loosely follows that of Hill, Gr.iffitl-rs and .fudge (1997), wl.rich is the clearesr that this aLrrhor h.rs scen,
across a long sect;on of the line, so that one could hold more confldence ir
estinrates in this case.
(1) The larger the sample size, I, the smaller will be the coefllcient standard errors.
fappears explicitly in .SE(d) and implicitly jn SE(lq). fappears impliciily since the f (-r, *i)r is from r = | Io T. The reason for this is simply that, at least for now, it ls assumed that every observation on a series represents a piece of useful information which can be used to help determine the coefficient estimates. So the
sum
Iarger the size of the sample, the more information wrll have been used in estimation
@
(.1,
ofthe parameters, and hence the more confidence will be placed jn those estlmates. (2) Both St(&) and .t6(p) depend on s2 (or sy. Recall from above that sr is the estimate
of the error variance, The larger this quantity is, the more dispersed are the residuals, and so the greater is the uncertainty in the model. lf s2 is large, the cjata points are collectively a long way away from the line.
(3) Thesumofthesquaresofthex,abouttheirmeanaDpearsinbothformulae-since
I (r, - i)2 appears in the denominators. The larger the sum of squares, the smaller the coefficient variances. Consider what happens if f (.r, - i)2 is smalj or large, as shown in figures 2.7 and 2.8, respectively. ln figure 2.7, the data are close together so that f (x, i)2 is small. ln this ftrst case, it is more difficult to determine with any degree of certainty exac|y where the line should be. 0n the other hand, in figure 2.8, the points are widely djspersed
@Eil on the
Effect
EmuEI
rf
Effect on the standard errors of large
standard errors of tho coefficient estimates when (.xr - i) are narrowly dispersed
50
A brit.f ovtniew of the clossicnl linaar rrgression model s Now, tr,r|ning to the standrl'd crr"ot'calculations,
BtrfTTI
it is necessary to o)
/>-ai
-l
-,
/
! ll
i'iltui v -l()
r.tu
: 255
rq tqo-s+
t,loSi
12 z J 1r,.5:
- 1 t{
\/..ur,urs+
- rr -lrn+
r)rrlt7g
as
ii = -59,l2+0,.15.r/
(,1.35) (0.0079)
The standald error estin)ates arc r.tsual)y placed in paretttheses unclt lclcvanI cocffi cicnt c:.til]l.rtcs.
x
the y-axis and hence it will be easier to determine where the line actually crosses the axis. Note that this intuition will work only in the case wnere all of the r, are positivel
2.9
Example 2.2 Assume that the following data have been calculated from a regrssion of .r'on a single variable.r and a constant over 22 observations
\-,. ,, - prnrnr r = 22. .i = 416.5. /2.-r.rt ' \-': * iQrs6sl PSS = Ilo,6 = /-^t
.r-'= 86.65.
Determine the appropriate values of the coefficient estinrates and their standard errors. This question can sirnply be ansrvered by plugging the appropriate nuntbers into the formulae given above. The calculations are
, r?
830101
_iq
86.65
Q2
Example 2.3
Sr-rppose
i,
,l =
=20.3*0.-5091.r,
14.38) 10.256I
)
.)i:(}+trl.\/ i, : _-59. tl *
0.35.r,
single (point) estimate of the unknowt.t popr.rlation p eter, /4. As stated above, the reliability of the point estitttate is ttrer
O.SOSf is a
cgt-cssion ntoricl
by the coefficient's standard error. The information fronr one or nrore of the sample coefficients and their stanclard errol.s cau be used to inferences about the population para',eters. so the estimate of the 'rake slope coefficient is f = o.sort, but it is obviors that this is rikely to 'umber \fary to sonre degree from one sanrple to the next. It might be of inter.est to answer the question,'ls it plausible, given tliis estil:rate, that the tlue population paraneter, B, could be 0.5? Is it plausible that could be t?,, f
rc.sfi rrg.
l r
case, the
H11
0.5, coil'esPoncling to an iltcrcilse in t'isl<, is not of interest. Il1 thl null ancl altct'nattve hypothcses wottld be specificd as
:P=05
11, fl.:0.5
This
pliol infot'ttt;rtiott shottld cotrtc frortt thc firtrtncial theory of thc Prol lertr uncler <:onsidclatiorr, ;rncl not flour nn cxamin;rtion of the estintatc' value of thc coefficicnt. Notc thilt thclc is always au cqualify ttnder th null hypothcsis. So, fbl cxltttrple, l. 0.5 wottld not be specified undt
thc ntrll hyPothesis.
I'he|e ale fwo ways to concluct a hypothcsis test: via thc tcsf of sigrriJican' ol vi;r lltc con.fidcncc irtlcnrtti approach, Both nret'hods celltre c a statisticfll compalison of the cstinratccl vitlr.re of tl-re coefficient, ancl i' value undcL the trr-rll hypothesis. Itt vet'y geueral tcrtl'rs, if the estinlatf value is a long way away fLonr tl-rc hypothesised value , the nul1 hypothes is likely to be rcjected; if the valtte trudet'the null hypothesis and the est mated value ale close to otte anotl.tcr, the r-rull hypothesis is less likell' t be rcjectecl. For exarttple, cotrsidet'/'i:0.5091 as above' A hypothesis th, the tnre value of ,4 is 5 is nrot'e likely to be rejected thrt'r a null hypothes that the trlte value of f) is 0.5. What is lequir-ed now is a statistical dccist' rule that will perlr-rit the formal testing of such hypotheses.
approach
H6:f-0.-5
Hr
:f#05 f
cor"rld
2.9.2
not 0.5. This would be known as a ru,o-sided test, since the outconres of both li < 0.5 and p > 0.5 are subsumed under the alternative hypothesis.
Sometimes. sone prior information may be availabre, suggesting for. example that p > 0.5 would be expected rather than p < O.S.ln this case, f '< 0.5 is no longer of interest to us, and hence a one-sided test would be conducted:
This states that the hypothesis that the true but unknown value of be 0.5 is being tested agai'st an arternative rrypotrresis where p is
Ho:f=0.-s
Hr
tf>0.5
The nolual distribution is a couvenient one to r-rse for it involves on flvo parameters (its tnean and variance). This makes the algebra invoh't in statistical inference considerably sinrpler than it otherwise would ha' been. Since.r; depends Partially on tr,, it can be stated that if rr, is nornal distributed, .r', will also be normally distributed. Further, since the least squares estimators are linear courbinations ' the random variables, i.e. 14: f u,,t,r, whete u', are effectively weighr and since the weighted suur of normal random variables is also normal distributed. it can be said that the coefficient estimates will also be nt
n.rally
In order to test h'?otheses, assuruptiou 5 of the CLRM nust be tlse' namely that i// - N(0, or) - i.e. that the error term is nornrally distribute'
Here the null hypotrresis that the true value of is 0.5 is beirrg tested B agalnst a one-sided alternative fhat , is nrore than 0.5. on the other hand, one colrld envisage a situation where there is pr.ror. i.formation that 19 < 0.5 is expected. For example, srrppose that an ,tvestment bank bor"rght a piece of new risk managenrent soffwafe thar is rntended to better track the riskiness inher-ent in its traclers'books ancl fhat , is sone measure of the risk that pr.evior-rsly tool< the vrlue O.S. clearly, it would'ot nake sense to expect the'isk to have r-ise', ancl so
distlibuted. T}tus
N(a.
var(a)) rrtd
p .-
S16, vrrlB))
Will
tl're coefficient estirrates still follow a norntal distlibution if thc ' ro|s cio not follow a trorntal dist|ibution? Well, briefly, tlte rusu'er is r.i: ally'yes', provided that the other assurnptions of the CLRM hold, atrd t saurple size is sufficiently large. The issue of non-not'maliry, how to tt fol it, and its cotrsequences, rvill be further discussed in chapter 4.
54
lntroductory Ecotrometrics
for
Finance
rj|.5?.errr
The normal
di
fable
2.2
stribution
Critical values from the standard normal versus t-distribution Significance level
50%
5"/o
(%)
N(0,1)
1.64 1.96
trc
2.5% 0.5%
2.57
2.13
2.78 4.60
@fEg t'distribution
The
.T
Standard'ormal variables can be constructed from d and, fl by subtract. ing the mean and dividing by the square root of the variance
cr-cl
viao
'
N(0,
l)
and
fl*B
,/ var( fi\
r r\\r!
I /
Replacing the true values of the standard errors with the sample es_ timated versions induces another source of uncertainty, and arso means that the standardised sratistics follow a r-distributio'with r - 2 degrees of freedom (defined below) rather than a normal distribution. so
eu
The square roots ofthe coefficientvariances are the standard error.s. unfortunately' the standard errors of the true coefficient values u'der. the pRF are never known - au that is availabre are their sample counterparts, trre calculated standard errors of the coefficient estimates, Sf(a) ana Sffi4).4
*ct
R_R
rn,.J
+ltrr
JI](A' -!/,1
sE(p) ''-z
This result is not formally proved here. For a fornal proof, see Hril, Criffiths and Judge (1997, pp. BS_90).
2.9.3
A note on the t and the normal distributions Tire normal distribution, srrown in flgure 2.11, sr.rouid be famiriar to read_ ers. Note its characteristic 'beit'shape and its symmetry arou'd the rlean (of zero for a standard normal distributioni.
a strjctly' these are the estinrated standard euors condjfional on the paramcter estirrnres. and so should be denoted S6(A) and .rE(B). but the additional Iayer ofhats \vill be ontitted lter since the nteaning should be obvious front the context.
A normal variate can be scaled to have zero rnean and unit vatian, by subtracting its mean and dividing by its standard deviatlon. There is specific relationship befween the r- and the standard normal distributio and the t-distribution has another parameter, its degrees of freedom. \&rtrat does the t-distlibution look like? It looks similar to a nornl distribution, br.rt with fatter tails, and a smaller peak at the mean, shown in figure 2.12. Sone exanrples of the percentiles from the normal and l-distributio; taken from the statistical tables are given in table 2.2. \Mren used in tl context of a hypothesis test, these pelcentiles become critical values. Tl values presented in table 2.2 would be those clitical values appropria for a onc-sidcd tcst of thc given significancc lcvcl. it can be scen that as the number of deglees of freedom for the distribution incLeases frour 4 to 40. the clitical values fall substantial Irr figule 2.12. lhis is rcprescnted by a gradrral incrcasc irr thc hcigltt tl-re distribution at the centre and a reduction in the fatness of the tails the number of degrees of freedonr increases. In the limit, a l-distributic' with an infinite number of desrees of freedorn is a standard nornral, i
56
r- :
the
t.
tffir|grFf
Rejection regions for
a twosided 5%
.f(x)
Putting the limit case, /a, aside, the critical values for the r-distribution are larger in absolute value than those from the stanclar.d nor.mal. This arises from the increased uncertainfy associatecl with the situation where the errol variance nlust be estimatcd. so'ow the l-distr.ibution is used, and fora given statistic to constitute tlre same amount of re'liable evidence against tlre nr.rll, it has to be bigger in absolute value fhan in circuurstances where the nomtal is applicablc. Ther-e are broadly two approaches to testiltg hypotheses uncler reglession analysis: the test of significance apploacl'r ancl the conficlcnce inter-val apploacl'r. Each of these will now be consider.ed ir.r tnr.n.
hvoothesis te$t
2.5Yo
reiection region
2,9.4
AssulDe
1.2.....
in box
f.
u I p.t., * tt,. r : The steps involved in doing a test of significar-rce ar.e shown
n.)
2.5.
h: li = F-' H':li<fr
(1) Estimate A, p and SE@), SE(.b in the usuat way. (2) Calculate the test statistic. This is given by the formula
ICSL.loltsltC: ------;-
B-8,
sL(p)
/? ?nl
where p- is the value of p under the null hypothesis. The null hypothesis is Ho : 19 = ,0- and the alternative hypothesis is Ht : fl * p- (for a two_sided test). (3) A tabulated distribution with which to compare the estimated test statistics is required. Test statistics derived in this way can be shown to follow a /-distribution with I - 2 degrees of freedom. (4) choose a 'significance level', often denoted d (not the sanre as the regression intercept coefficient). lt is conventional to use a significance level of 5%. (5) Given a significance level, a rejection region and non-rejection region can be de. termined. If a 5% significance level is employed, this means that 5% of the total distribution (5% of the area under the curve) wiil be in the rejection region. Trrat rejection region can either be split in half (for a two-sided test) or it can ail fall on one side ofthe .r-axis, as is the case for a one_sided test For a two-sided test, the 5% rejection region is split equally between the two tairs, as shown in Iigure 2.13. For a one-sided test, the 5% rejection region is rocated sorery in one tair of the distribution, as shown in figures 2.!4 and 2.1s, for a test where tlre alternaIve is of the 'less tl'ran' form, and where the alternative is of the 'greater than' form,
respectively.
EMil
H,:A>
/ (x)
H1:f=fi-,
B-
IC ieclion
5"/. region
\/
mod.el
(6) use the /-tables to obtain a critical value or values with which to compare the test
statistic, Ttle critical value will be that varue of
region.
(7)
Finally pedorm the test. If the test statistic ries in the rejection region then reject the null hypothesis (H6), else do not reiect H".
but this difference is 'normalised'or scaled by the standard error.of the coefficient estimate. Tire standard error is a measure of how conflclent one is in the coefficient estimate obtained in the first stage. If a standard error is small. the value of the test statistic will be large relative to the
case where the standard error is large. For a srrall standard error, it would not Iequire the estin-rated and hypothesised values to be far away from one another for the null hypothesis to be rejected. Dividing by rhe standard error also ensures that, under the flve GLRM assumptions, the test statistic follows a tabuiated distribution. In this context, the number of degrees of freedonr can be interpreted as the number of pieces of additio'al infor'ration beyond the rninimun.r requirement. If rwo parameters are estimated (a and p - the intercept and the slope of the iine, respectively), a nrinimum of fwo observations is required to fit this line to the data. As the number of degrees of freedom increases, the critical values in the tables decrease in absolute terms, since less caution is required and one can be more confident that the results
Steps 2-7 require further comment. In step 2, trre estimatecl var'e of p rs cornpared with the value that is sr"rbject to test undef the null hypothesis,
However, one potential problem with the ttse of a fixed (e'g. 5o ) srz of test is that if tl'te sample size is sr,rfficiently large, any null hypothesi can be rejected. This is palticr"rlar-ly wolt'isoltle in finance, where tens t' thousancls of observations or lllore are often available, What happens i that the standard errors |eclrrce as the santple size increases, thUs leadin to an iucrease in the value ofall r-test statistics.This plobiem is frequentl overlooked in enrpirical wot'k, but sollle econometlicians have suggestc that a lower size of test (e.g. 1%) should be r-rsed for large samples (see' ft' example, Leanter', 1978, for a discussion of these issues). Note also thc r.rsc of tcr-nrinology in counection with hypothesis test' it is saicl that the null hypothesis is either rejected or not rejected. It incorrect to state that ifthc null hypothesis is not rejected, it is'acceptet
(although this error is fi'equently made in practice), and it is never sai that the altet-native hypothesis is accePted or rejected Oue reason wl it is not sensible to say that the null hypotl]esis is'accepted'is that is impossible to know whether the nnll is actually true or not! In an given situation, mauy null hypotheses will not be rejected. For exatlpl, suPPose that Hn : p : 0.5 atld Ho : d : 1 a|e seParately tested against tlr relevant two-sided alternatives and neither null is rejected. Clearly then woulcl not tlake sense to say that'H1) : p :0 5 is accepted'and'H6 : p = is accepted', since the true (but ur-rknown) value of ,4 cannot be botlt 0 ancl 1. So, to suntnarise, the trull hypothesis is either rejected or nt rejected on the basis of the available evideuce.
2.9.5
are approprrate. The significance level is also so'retimes called the size of the test (note that this is compietely different from the size of the sample) and it defermines the region where the null hypothesis under test will be rejected or not rejected. Remember that the distributions in figures 2.13-2.15 are for a random variable. purely by chance, a random variable rvill take on extreme values (either large and positive values or large and negative values) occasionally. More specifically, a significance level of 5?6 means that a result as extreme as this or more extreme would be expected oniy 5% of the time as a consequence of chance alone. To give one illustratio', if the 5% critical value for a one-sided test is 1.68, this irnplies that the rest statistic would be expected to be greater than this only 5g,o of the tirrre by chance alone. There is nothing magical about the test - ail that is done is to speci8/ an arbitrary cutoff value for the test statistic tl-rat deternrines whether the null hypothesis would be rejected or not. It is conventional to use a 5% size of test, but l0% and 1% are also commonly usecl.
repeated samples, 95% of the time, the trtte value of p will contained rvithin this interual. confldence intervals are almost invariab
in many
estimated in a fwo-sided folm, although in theory a one-sided inten' can be constructed. constructing a 95% confidence inten'al is equivalel to using the 5% level in a test of sigr-rificance'
The test of srgnlflcance and confidence interval approaches always give the same conc/usion
2.9.6
Uncier the test of significrllce rpirt'oach' the nttil hypothcsis thnt p = u,ill not bc rejected if the test statisfic lies rvithirl tltc trorl'tejcctiott t'r'gtc' i.c. if the foilorving cor.rditior.r holds
-t,,tr '
,4
* rl.
)
)Lll -
-.*t,,',
60
reg,rcssictn ntodel
6i
(2) Choose a significance rever, c (again the convention is choosing a (l _ a)tjoo/" conf,dence interval
i.e. 57o significance level
Co nfi d e
ce i nte r v a I a pproa ch
Find t,,.;,
0.5091
-l
ho.sq
*2.086
(3) Use the r{ables to find the approprlate critjcal value, whjch will again have Z*2
Find
t,.,.,,
0.2-56 |
- -'.''1
pL
,.,,
ll rr = *2.086
Do not reject ll0 since test statistic lies within non-rejection reglon
lies
Note that a centre dot (.) is sometimes used jnstead of a cross (x) to denote when two quantities are multiplied together. (5) Perform the test: if the hypothesised varue of p (i.e. B.) rres oulside the confrdence intervar, then reject the nuil hypothesis that B = B-, otherwise do not reiect the nuil.
if
i * f' 1- | ,,t. SErf t -r.,.;,. = r.e. one would not reject if B - t,,,,. Sf(p) S f. t,+ t,,.it. SE(B)
SErf,t
the same conclusion by construction. one testing approach is sir.nply algebraic rearrangement of the other.
Example 2.+ Given the regression results above
just the rure for non-rejection under. trre confidence interval approach. so it will arways be rhe case that, for a given signiflcance revel, the test of significance and confidence intervar approaches will provicle
But this
is
a'
'fhe rcsults of the test accor.cling to each approach are shown in box 2.' A couple of coniltlents are in ot.der.. First, the critical value from th l-distribution that is r.eqr,rir.ed is for 20 degrees of fi'eedom and at the 5' level. This ntealts that 5% of the total clistribution rvill be in the |eje, tion region, and since this is a rwo-sided test, 2.5% of the distributior is requirecl to be containecl in each tail. From the symmerly of the ciistribution aroltnd zero, the critical values in the upper and lower ta will be equal in rnagnitude, but oPposite in sign, as shown in figure 2 1r what if instead the researcher wanted to test H0:d = 0 or Ho:f = In order to test these hypotheses using the test of significance approacJ the test statistic would have to be reconstructed in each case, although tl: cr.itical value would be the same. On the other hand, no additional u'ot would be required if the confldence interval approach had been adopter
@Eil values
(2.3'1)
/(.r)
,r;:zO.l*0.5091.r,
(I
4.38) (0.256 I )
the h5pothesis that p : 1 against a two-sided alternative. This hypothesis might be of interest, for a unit coefficient on the explanatory variabre implies a 1:1 relationship berween movenrents in.r.and .,-'o'e,'ents i'
The null and alter.native hlpotheses are respectively:
using both the test ofsignificance and confidence interval approaches, test
r,.
2,SYo
rejeclion region
rejection Iegion
2 'SYo
:fl-1 Ht:fi*l
H11
\
-2.086
+2.086
52
lntroductory Econometrics
for
Finance
A brief
since it effectively permits the testing of an infinite number of hypotheses. So for example, suppose that the researcher wanted to tesr
H1;
:f=0 :ft'0
versus
H1
the effect of tlie size of the tcst on the conclrtsiou is easier to addres r-rndet' the tcst of significatrce appl'oach' caution shoulcl rher.efor-e bc usccl when placing emphasis on or makitr clecisions i11 the coutext of ntarginal cases (i.c. in cases where the nu is only.just lejcctcd or lrot rc.iectccl). In this sitrtation, the appropIirt conclusion to dt';tw is th:lt thc rcsults lit-c tnat'gitlal rnd that no strotlg ir
lerencc caD lre nt:rclc ouc wilv Or-thc othcr. A thoroLlgh eu'rpi|ical anaiys shoulcl involve concluctiDg a scnsitir.'ity:rrlalysis otl the resttlts to detc
fr
and
Hr:lJ=2
versus H1 :
fi
lZ
In the first case, the null hypothesis (that f = 0) would nor be rejected stnce 0 lies within the 95% confidence interval. By the same argument, the second null hypothesis (that f =2) would be rejected since 2 lies outside the estimated conf,dence interval.
On the other hand, note that this book has so far considered only tl.re lesults under a5% size of test. In marginal cases (e,g. H6 :19 1, where the = test statistic and critical value are close together), a completely different answer may arise if a different size of test was used. This is where the test of significance approach is preferable to the construction of a confidence interval. For example, supPose that now a 70% size of test is usecl for the nuli irypothesis given in example 2.4. Using the test of significance approach,
te.tr
ntine whctitcr.usir-rg a cliflircrlt sizc of tcst alters the conclusiorls lt wofth st;ttiltg again that it is convcntronal to considel' sizes of test of 10' 5,% ancl 1{x,. If thc conclusion (i.c. 'r'e.iect'or 'clo trot |eject') is robnst changes ir-r the sizc of the tcst, then One can be tnole confident that tl, conclusions a|e approp|i;lte. If the oLltcollle oF tlre test is qualitatively: tered when thc sizc of the test is n'rodifiecl, the cotrclusion n-ltlst be tlt, there is t'to conclusion olle way ol' the other! It is also \vor.th uoting that if a given r-rr.rl1 hypothesis is rejected using
t
significance level, it will also auton.ratically be rejected at the 5% Iev( so that thele is no need to acttlally state the latter' Dougherry (199 p. 100), gives the anaiogy of a high jumper. If the high jumper cau cle 2 metres, it is obvious that the juntper could also clear 1.5 netles. Tl levt 1% signiflcance level is a l-righer hurdle than the 5% sigDificance significance, lt wr Similarly, if the null is Dot rejected at the 5% level of autonratically not be rejectecl at any strongel level of significance (e.g. 1') In this case, if the jumper carlnot clear 1,5 metres, there is no way s/1 will be able to clear 2 ll-retres.
1%
.rtari.tric:
t {
SE(P)
2.9.7
lfGi_ :
I
0.5091
_1.e17
level (so that 5% of the total distribution is placed in each of tl.re tails for this fwo.sided test), the required critical value is t211111"y, *1.72-5. So = llow as the test statistic lies in the rejection region, H6 woulcl be r.ejectecl. In order to use a 109'o test under the confidence interval appr.oach, the interual itself would have to have been re-estilnated since the cntical value is entbedded in the calcr-rlation of the confidence interval. So the test ofsignificance and confldence interval approaches both l-rave their relative merits. The testing of a number of clifferent l1lpotSeses is easter under the confidence interval approach, while a copsiclelation of
as above' The only thing that changes is the critical r-value. At the 10%
'
thatitis.insignificant''Finally,ifthenullh}'pothesisisrejectedattj
the result is terned 'liighly statistically significant" Note that a statistically significant result may be of no practical s nificance. For example, if the estin'rated beta for a stocl< under a CAI' regression is 1.05, and a null hypothesis that fJ:1is rejected' the I'esr will be statistically significant. But it may be the case that a slightly high bcta will r.nake no differcnce to an investor's ciroice as to whethcl to i) the stocl( or Ilot. In that case, one rvould say that the lesult of the t' was strtistically significant but financially ol' plactically insignificant.
1% level,
Table
2.3
*
reduce the chances of both is to incrcase the sample size or to selei a samplc with more valirtiotr, thus inclcasing the antount of infornr' tion upon which the lesults of thc hypothcsis test are based. In practicr llp to a ccIt;rit'r levcl, typc Iclrors:rre usr"rally consitlerecl t.note seriot irncl hence a stuall sizc'ol lcst is usually choscn (5% or 1% are the nlo'
conl lllon
).
Result of
test
i! true Typelcrlttr':a
Hs
H6 is false
,/
-lyl)('Il
-_
(llol .- I
2'9'8
Crassifyingthe errors that can be made using hypothe.srs tests H1, is usually rejected if the test statistic is statistically sienifica't at choser significance rever. Trrere are rr,vo possible errol.s that co'rd
(1) Rejecting (2) Not
H11
be urade:
when
Hrr
it
'ejecting
whe' it
was reaily true; this is called atylte I error. was in ract false; this is cairecr a 4,pe II crror.
Tlie possible scenarios can be summar-isec-l in table 2.3. T'e probabiliry of a type I error is just cr, the siguifica'ce level or srze oftest chosen. To see this, recall what is meant by,significance'at the s% level: it is only 5% likely that a result as or lrore extrerne as this coulci have occurred purely by chance. Or, to put this another way, it is only 5% likely that this null would be rejected when it was in fact true. Note that there is no chance for a free lunch (i.e. a costless gain) here! \Mrat happe's if ti-re size of the test is reduced (e.g. fi-om a 5% fest to a 19/o test)? The chances of making a rype i error wourd be reduced. .. but so u'ould the probabiliry that the null hypothesis r.r'ould be r.ejecteci at ail, so i'creasing the probabiriry of a rype II error'. Trre two cornpeting effecrs of reducing the size of the test can be shown rn box 2.g. So there always exists, therefore, a dir-ect trade-off between wDe r and rype II errors wrren crroosing a significance lever. T)re oury..v to
Thc plobability of a rypc I ct'r-ot' js tJrc plobability of incot'rcctly rejct ing a collcct nrrll hypothcsis, which is rlso the size of tl're test. Alloth( inrportrnt pie'ce of tet'nrittolctgy in thrs ;ilca is the pot't,er 0f .l lc.sl. The pow, ofa test is dcfincd as thc plobability of (apploprirtely) r'ejecting atr itrcc, lect null hypothcsis. The powcr of the test is also eqr-ral to one lttlltus tll probabiliry of a type II c'r't'or'. An optinral tcst wouid be otre with an actual test size that ttlatcht the nominal size ancl which hacl as high a power as possible. Such a te would imply, fbl ex:rntple. thet r-rsi:rg a 5'./, significatrce level wouid resr.i in the nr.rll be ing lcjected cxactly 5",' of the tin-re by chattce alone, atr that an iucoLLect nr-ri1 hypothcsis rn'ould be rejected close to 100% of th time.
slalt.rlt(:
'-......'.-..:T
fi-f'.
sr(p)
(2.3
H1y:f:0 H1 :Bl0
i.e. a test that thc population parameter is zero r1;aiust a fwo-sided altt native, tl-ris is knor.vn as a r-ratio tcst. Since p- :0, the cxpressiou in (2.3 collapses to
l(.\l.\l(1lt\lt( :
11
Less likely Lower to falsely +chance of Reduce size+More strict +Reject null/re)ec| type lerror of test (e.g. criterion for hypothesjs\
5%
ta
I%) rejection
less
often
N4ore likely
to
Higher
incorrectly +chance of
not
.s[(n
12.:l
)
reject
type ll error
Thus the ratio of the coefficient to lts stalldard cn'or'. given by th cxplcssion, is l<nou'r.r as the t-r1lf i0 or l-srdti.stic.
b:'
F'"
F'.
F
model
6t
Example 2.5
that we have calculated the estimates for the inter.cept ancl the slope (1.10 and -19.88 respectively) and tl-reir corresponding standard errors (1.35 and 1.98 respectively). The r-r'atios associated with each of the
Suppose
I
I
.tt r-r'atio
Note that
Cocfficient I.l0
n7
-t9,88
t.98
10.0J
Some aurhors placc the r-ratils itt patctrthcscs below the correspondin; coefficient estimates rather than tl're standard errors. One thus needs t( check wl'rich convention is being r.tsed itr each particular application, anr also to state this clearly whcn pt'esenting estirlatior-r I'esults. Thele will now follow two finance casc studies that involve only thr estimation of bivariate lineal reglession models and the constructlon an( interpretatiorr of r-rlttios,
I..15 0,8i -
f - I, is equal to 15-3=12. The 5% cr.itical value for this fwo-sided test (renember, 25% in each tail for a 5% rest) is 2.179, while rhe 1% rwo_sided critical value (0.5% in each tail) is 3.055. civen these /-ratios and critical values, would the following null hypotheses be rejected?
H0:cr:0? Hs: B-0?
(No)
(
a coefficient is negative, its r-ratio will also be In order to test (separately) tl're null hypotl.reses that tr : 0 and'egarive. I = 0, the test statistics would be compared rvith the appropriate critical value frorn a l-distribution. In this case, the nuntber of degrees of fi.eedorn, given by
if
2,tl
nutt'llr particular exatttine whether any'beat the market', He uset funds, and in a sample of anuual returlls on the poltfolios of 115 nrutuai frtnds fron 1945-64. Each of the 115 fi-rnds was sub.jected to a seParate OLS time serte rcgression of the forrtt
Rl,
R1
= aj *
lJi(R,,,
Rx)
ttlr
les)
If H6 is rejected, it would be said that the test statistic is signr/icnnf. If the variable is not'signiflcant', it means that while the estinated value of the coefllcient is not exactly zero (e,g. 1,10 in the exantple above), the coefflcient is indistinguishable statistically from zero. If a zelo were placed i' the fltted equation instead of the estimated value, this would lnean that whatever happened to the value of that explanatory variable, the dependent variable would be unaffected, This would then be taken to nean tltat the variable is not helping to explain variations in ,r, and that it could therefore be removed from the regression equation. For example, if the rratio associated with.r had been -1.04 rather than -10.04 (assuning that the standard error stayed the same), the variable would be classed as insignificant (i,e. not statistically different from zero), The only insignificant term in the above regression is the intercept. There are gooci statistical reasons for always retaining the constant, even if it is not significant: see chapter 4.
worth noting that, for degrees of freedom g.eater thar al.or.ircl 2s, the 5% rwo'sided critical value is apploximately *2. so, as a rule of thunrb
is (i.e. a rough guidel, the null hypothesis would be r.ejected exceeds 2 in absointe value.
where Ru is the return on pol'tfolio / at time t, R7i is the return on risk-free proxy (a l-year government bond), R,,,, is the return on a ]nal ket portfolio pl'ox!, rr;1 is an error term, and a1, p.i arc parameters to b' estimated. The quantity of interest is the significance of (IJ, since thr parameter defines whether the fund outPerForms or underperforms th
market index. Thus the null hypothesis is given by: H6 : ai :0. A positiv' and significant a, for a given fund would suggest that the fund is abl to earn significant abnormal retufns in excess of the market-required r' turn fol a fund of this given riskiness' This coefficient has becone knowr as'Jensen's alpha'. Sorne su[Ilrlary statistics across the 115 funds for th estinated regression results for (2.52) are given in table 2.4.
Summary statistics for the estimated regression results for (2.52) Extremal values
Mean
Table
2.4
value
'
Median value
Minimum
- 0.080
0.219
10
Maximum
0.058 1.405
20
It
ri, l!
Sample
-0.011
0.840
-0.009
0,848
19
size
17
if the r-statistic
Ptrblishc'ts
68
A brief ovttricw of the classicul li:iear rcgrcssiott rnodal Summary statistics for unit trust leturns, January 1979-May 2OO0
Mean
(%)
ESEftN
Freq uency
j-i
Table
2.5
Minimum
(%)
Maximum f/")
Median
(%l
of transact ons costs) source: Jensen (1968), Reprinted with tlre permission of Blackwell Pub ishers
.i {)
Average nronthly
retunl, 1979-2000
Stlnd:rld dcvration of rcturns over tlnlc
li
J.I
1.0
6.9
-l
t-ratio
EEil
Freq uency
Thc appt'opriate clitical valrte fot' a two-sided tcst of d/ = 0 is approx' ir-nately 2.10 (assr.tn-ring 20 yeals of annr.tal data leading to 18 deglees of freedom). As can be seen, only five funcls have estimated r-ratios gleater tltan 2 and are therefore intplicd to hrvc been able to outPelform the r.uarket befor.e transactiolts costs a|e takeu illto accollnt. IDterestingly, fir'e firms hlve also significantly unde|per'fortned the tnalket, with /-ratios
Source:
l:
10
\\/lren transactions costs arc tal(en into account (figure 2 18)' only oue fr-rncl out of 115 is able to sigr-riflcantly outperfornr the trarl<et, rvhile 14 significantly utrderperforn-r it. Given that a uouritral 5% nvo-sided size of test is beir]g used, one rvould expect rwo or thlee fr-rnds to'significantll' beat the market'by cha|rce alone. It worilcl thus be concluded that, during the sanple pel.iod stndied, uS fund lllaltagers appcaled ullable to systen'
atically generate positive abnormal retLlrns.
of -2 ol
less.
.r
-l
-:
I
,-ratio
2.t2
Can UK unit
As tabie 2.4 shows, the average (defined as eithel the nrean or the nredian) fund was unable to 'beat the market', recording a negative alpha in both cases. There weLe, however', some funds that did ntanage to perfornl significantly better than expected given their level of risk, with tl.re best fund of all yielding an alpha of 0.058. htterestingly, the aver.age fund had a beta estimate of ar-ound 0.85, indicating that, in the CAPM context, most filnds wcre iess lislq'than the malket index. Ti-ris resuit utay be attributable to the fr.rnds investing predon-rinantly in (mrtule) bJue chip stocl<s lather than surall caps. The n-rost visual nrethod of presenting tire resr:lts was obtained by ploteach /-ratio catefloly fol the aipl-ra coefficient, fir'st gross and then net of transactions costs, as in figr-rr.e 2.17 :nd fiorrrc 2 l8 rernert ivg]r,'.
a method for conducting Jensen's study has proved pivotal in sr-rggesting erlpir.ical tests of the perfo|rnance of fr,rnd nanagefs. Hower,er, it has been
criticised on several grounds. One of the most illlportallt of these in the context of this book is that orlly befween 10 and 20 aunual obselvations rvere used for eacir leglessioll. Such a smail llunlber of observations is r.eally insr-rfficient for. the asynptotic theol'y underlying the testing pfocedure to be rralidl\' invoked A variant ou Jenseu's test is now estimated in the cot]text of thc Uii market, by conside|ing montl'rly retunts on 75 equity r,rnit tt'ttsts. The clata cover the pelioci Jantlary 1979-May 2000 (257 obselatious fo| erch tirucl). Soure sLillltlafy statistics for tire funds at'e pt-esentcd il'r table 2 5 Flor.n these sr111111ary statistics, the avefage colltintlor,lsly cotttpoltDde'cl
r.etufl is
1.0%
70
Introductory Econometrics
lar
Finance
rcgrc.s.siott rnodcl
Table
2.6
c,APlr4
Eslimates
u(Vc)
P
of
Mean
Minimum
Maximum
0.33
1.09 3.11
Median
(1) Ihatthe'overreacttoneffect'isjustanothermanifestationofthe'sizeeffect',Thesize
effect is the tendency of small firms to generate on average, superior returns to large firms. The argument would follow that the losers were small firms and that these small firms would subsequently outperform the large firms, DeBondt and Thaler did not believe this a sufficient explanation, but Zarowin (1990) found that allowing for firm size did reduce the subsequent return on the losers'
*0.02
0.91 On a
t-Iatio
*0.07
0.54 0.56
,0.03
0.91
0.2s
(2\ Thatthereversalsoffortunereflectchangesinequilibriumrequiredreturns.Thelosers
Ill?[EEfil
Performance of UK unrt !rusts.
197
3000
2500
are argued to be likely to have considerably higher CAPM betas, reflecting investors' perceptions that they are more risl{y. Of course, betas can change over time, and a substantial fall in the flrms' share prices (forthe losers) would lead to a rise in their leverage ratios, leading in all likelihood to an increase in their perceived risklness Therefore, the required rate of return on the losers will be larger, and their ex post performance better. Ball and Kothari (1989) find the cAPM betas of losers to be considerably higher than those of winners.
9-2000
2000
1500
2.13
1000 500
2.73.7
rud*s *JoP*Sg*q**tr"C.*tr"*f,"rJ{,*.*rygf*tr"C*Jc],.t*
wide variation in the performances of the funcls. The worst-perforrring fund yields an average return of 0.6% per month over the 20-year- pe_ riod, while the best would give 1.4% per nonth. This variabiiiry is further demonstrated in figure 2.19, which plots over tin.re the value of 100 invested in each of the funds in January 1979. A regression of the form (2.52) is applied to the UI( data, and the sun_ mary results presented in table 2,6. A number of features of the regression results are worthy of further comment. First, rnost of the funds have estimated betas less than one again, perhaps suggesting that the fund managers have historically been risk-averse or in'esting disproportionately in blue chip conpanies in mature sectors. second, gross oftransactions costs, funds of the sample of 76 were able to significantly outperforrn the 'ine market by ploviding a significant positive alpha, while seven funcls yielded significalrt negatirre alphas, The average fund (r.vhere 'average' js measured
using either the mean ol the median) is not able to ear. any excess retul.n over the required rate given its level of risk.
all firms traded on the London Stock exchange. This phenonrenon seenls at first blush to be inconsistent with the
(box 2.9).
ef1
cient marl<ets hypothesis, and Clare and Thonras Proposc rwo explanettotr Zarowin (1990) also flnds that 80% of the extra return avallable frot' holcling the losers accrues to investor.s in Janualy, so that almost all c the 'overreaction effect'seems to occur at tl-re stalt of the calendal yeal'
2.13.2
MethodotogY
random sample of 1,000 firtrls and, fot' each, thc calculatc the nontl-rly excess retuflt of the stock fot'the tlrat'kct ovel-a 12 2,1- or 36-nlonth prct'iod fbr eaclt stock
Ciar-e aud Thotnas take a
1
LJi,= Ri,-
R,,,,
|=
1.,...ri;
Introductory Eanometrics
for
Finance
A hriel ovcru/crl
Table 2.7
Ranking
All Months
0.0033 0.0036
rctun) (lIffctclr(c
ri,;
0.3 7'l"
-0.00031
(0.2e)
,- 0.00034
rr=lJ 0.001 1 -0.0003 L68'l( 0.0014 '' (2.01) (2.01) 0.010 (0.21)
0.00147'-
ri="10
0.0129 0.011s
1.561,
0.0013
(l.ss)
0.0013
(1.41)
ri,.
-0.o22 (- o.2s)
*0.002s {*0.06)
0.0009 (1.0s)
"
10-o/n
and 5% levels.
Then the a\/erage monthly return over each stock 36-month peliod is calcr:lated;
tx p '\-l "r -..- / |t:1 vtt
respectively.
Sorrlcc: Clarc and Thornas {1995).
Publishers.
(2.s4)
The first leglession to be perfoured is ofthe excess LetuLu ofthe loser over the winners on a constant only
Rp1
and loser portforios (the top 20% and bortor.r.r 20% of firms i'the por.tfolio folmarion per.iod) are denotecl by Rj,f and Rf-,, respectrvely. Define the diffelence bef'"r,een these as Rn, = R!,, * n])
periods a.d 18 i'dependent traci<ing periods. By similar.argunents, /r : 2 gtves 9 independent periods and n = 3 girres 6 ilclepenclent per.iocls. Tl_re r'eturn for each rnonth over the 1g, g, or. 6 periocrs for. the wir'er
The stoci(s are then ranl<ed frorn highest avefage r.eturn to lowest and fro'r these 5 portforios are formed and returns are carculatecr assurning an equal weighting ofstocks in each portfolio (box 2.10). The same sample rength ri is used to monitor. the perfbrma'ce of each portfolio. Thus, for exanple, if the portfolio formatron period is one, two or three years, the sr-rbsequent portfolio tracking period ,"vill also be one, two or three years, respectivery. The' another portforio forrnation period follorvs and so on until the sample periocr has been exhaustecr. How rnanv samples oflength n will there be? l : 1, 2, or 3 years. First, suppose rr : 1 year. The pr.ocednre adopted would be as shown in box 2.11. So if l : 1, there are 1g independent (non-overlapping) observation
:ctl*t11
rr'here 17, is an error telnt. The test is of r.r'hether rrt is significaltt alt, positive. Hor,r'ever, a significant and positive or is not a sufficient cor-rditio for the overleaction effect to be confirrned because it could be owing t higher reti.u'ns being required on loser stocks owing to loser stocl<s beiu. tnore risky. Tire solution, Clare and Thomas (1995) argue, is to allow fc risk differences by reglessing against the ntarl(et I'isl< premiunr
Arr,
o, + fl(.tl,,,t - Rr,) +
,,
12.t,
'er'
rvhere R,,,, is the leturn on the F-TA All-shale, and R1, is the re-turn on UK gover-nmcnt thlcc-rronth Treasuly Bill.'fhe results fbr r.rch of tires frt'o |eg|essions are prcsented in table 2.7, r\s can be seen by compaling the rctr.rr-ns ou the wirrirc.r's and losels i' thc first two ro\\rs of tablc 2.7, 12 ntonths is uot a sulficit'ntly long tnl fot'losers to become winneLs. By the f"vo-yeat't1':lckiug holizon, hon'evc the losels have become r,r'iuners, and sir-nilarly fol the thrcc-ycar srrtrple: TI'ris translafcs into an average 1.68% highel retul'll olt the losels than tlr
74
rL:y,ression ntorlel
winners at the t\,vo'veai l-rorizon, and 1.55% higher return at the three-yeli hcrizon. Recall that the estimated value of tl-re coefficient in a regr.ession ofa variable on a constant only is equal to the average value ofthat var.!able. It can also be seeu that the estimated coefficients on the coltstant tern'rs for each horizon are exactly equal to thc differ.ences between tire lcturns of the losers and the wiurtcrs. This coefficient is statistically siglificant at the two-year horizon, and marginally significant at the three-year horizon. Iu the second test regression, I represents the differ.ence behveen the market betas of the winuer and loser portfolios. None of t5e beta coeffi-
Table
2.8
Coefficient
Std.
Error t-Statistic
0.817569
0.L)257
Prob. 0,4167
0.3 581
c
RFiJTURIiS
0.363302 O, 123860
0.444369 0. r 33790
81.
In flact, the uLrll would hlrve becn lc'jccted at the 12% Ievel or hight To see this, consider conducting a selies of tests with size 0.1%,0.2'
0.3y", 0.4%, .
cient estimates a1'e even close to being significant, ancl the ilclusiol of the risk term tnakes virtttally no difference to the coefficielt values 6r significances of the intercept terns. Removal of the January returns from the samples reduces the subscquent degree of overperformance of the loser portfolios, and the signiF icances of the ri1 tel'lrrs is somewhat reducecl. It is concluded, thelefore, that only a Part of the overreaction phenomenon occuls in Ja11aly. Clare and Tiromas then proceed to examine whetlter the overreaction effect is related to firm size, although the results are not presented here.
..
1%, .
..,
5%,
..
10%,
...
2.13.3
Conclusions The main conclusions from Clare and Thomas'study are: (1) There appears to be evidence of overreactions in ul( stock returns. as found in previous US studies. (2) These over-reactions are unrelated to the CAPM beta. (3) Losers that subsequently become winners tend to be srnar, so that most of the overreaction in the ul( can be attributed to the size effect.
statistic will n-reet and this will be the p"value. p-values ale alnrost ahval provided aLrtonlatically by softrva|e packages. Note horv usefttl they ar, They provicle all of the information recluired to conduct a hypothesis te: withor.rt requiring ofthe IesealcheI the need to calculate a test statistic c' to find a critical value from a t;rble - both ofthese steps have already bee t;rken by rhe p.tcl<rge in prodtrcing thc 7,-v3lus. The 7'-value is also usetl since it avoids the requir-enrent of specifliing an arbitrary significanc levei (a). Sensitiviry analysis of the effect of the significance level on tir conclusion occurs automatically. Informally, the 2-value is also often referred to as the probabilfty c being wrong when the null lrypothesis is lejected. Thr:s, for example, if p-value of0.05 or less leads the researcher to reject the null (equivalent t a 5% significance level), this is eqr.rivalent to saying that if the probabilit
n innnrrartlrr roia
p-value has also been terrrred the 'plausibiliry' of the r.ru1l hypothesis; st the smaller is the p-value, the less plausible is the null hSpothesis.
5%,
T1t
2.I4
2.15
Reload the'hedge.wfl'EViews worl< file that was created above. lf rt re-exanrine the results table from the returns regression (screellshot 2. on p.43), it can be seen that as well as the parameter estinlates, EVie\\ autonatically calculates the standard errors, the /-ratios, and the /)-valltt' associated with a two-sided test of the null hypothesis that the tlue valLt
iret
s Is the nr.rll rejected at the i07; level? e Is the nr.rll rejected at the 20% level?
level?
No No
]'e_s
(table 2.8) for ease of interpretation. The third columu presents the /-ratios, which a|e the test strltistics fi' festing the null hypothesis that the true values of these par-anlcters lll zero against a rwo sided alternative - i,e. these statistics test flo : t{ : (} 1t1' slls Ht :a I0 ir-r the first t'ow of numbers and Hrr :d :0 versr"ts Hl : f =
I I
76
Testsfi'^lald
the seco'd. The fact that these test statistics ar.e both very sn-ralr is in_ dicative that neithcr ofthese'ut hypotheses is lir<ely to be rejected. This conclusion is co'firmed by the 7r-values give' in tl-re firal colu'r'. Both 2values are corsiderably large. than 0.1, iudicating that the co'.esponcling test stafistics al.e llot even significant at the 10% lcvel. Suppose now that we wantecl to test thc nuil ltypothcsis that FI0 I i4 = 1 lrthel than Ho . t'l = 0. We cor.rlci tcst this. or.any other hypothcsis ;rbout the coefficie'ts, by hand, usi.g trre info.nration wc alr.cady have. Br"rt it is easref to ret EViews do the wo'k by typing view ard then coefficient
i'
*
Wald Test:
Lquation: REI1IRNRITC
Test Statistic
F-stat i sti
Chi-sqr.ra
c:
Valtre
,12.8 81 5 5
4
Probability
{1. (r3)
1
lc
2.884 55
0.0000 0.0000
Nolrtrrlisccl llestljction
(:
0)
Std.
I}'r
ete's
i'a
also nonlinear restrictions, which car'ot be tested plocedure for. infer.ence described above.
Wald Test: Equation: LE\,TLREC
Test Stafistic F-statistic Chi"square Value 0.56s298
0.565298
slope' Type c(2)=1 and clicr< or(. Note that usir.rg trris software, it is possible to test ur'ltiple hypotheses, whicli wiil be discussed in crrapter.3, arcr
- coefficie't Restrictions.... EViews clefines all of thc ]);rra'vecto. c' so that c(1) will be rrre ir,ter.cepr ancl c(2) wilr be rhe
I + C'(l)
0.8761.10
0.133790
2.16
example 2:
df
11,,
1
Probability
64)
0,4549 0.4s21
This exercise r,r'i11 estimate atrd test sonrc hypotheses about the CAPM beta for several US stocks. |ilst, Open a new worl<file to accourntodate monthly data contmencing in January 2002 and cnding in April 2007. Then import the Excei file'capm.xls'. The file is olgatrised by observation and contains six colurnns of numbers plr.rs the clates in the fir'st colurnn, so in the 'Nanres for selics or Nuurber if named in file'box, fype 6. As befole, do
Value -0.0"t7777
-'t +
c(21
not inrpolt rhc dates so thc data sran in cell 82, Thc nionthly stocl< priccs of four companies (Ford, Cene ral Motor-s, Microsoft and Sun) will appeal as objects, along rvith index values fof the S&P500 ('sandp') ar-rd three-month US"Treasury bills ('ustb3ur'). Save the EViews worl<file as 'capm.wk1' In order to estimate a CAPM equatiolt fol the Ford stock, for exarnple, rr'e need to first transform the price series into leturns and then the excess returns over the risk free rate, To transform the series, click on tire Cenerate brrtton (Genr) in the rvor'l<file window. In the ncw window. rype
RSANDP=100-LOG(SANDP/SANDp( *
1
only one paraneter, the two test statistics ('F-statistic'ancl ,x-sqrare,) will always be ide'tical- Trrese a'e equivalent to conducti'g a r-test, a'd these alternative fo'nulations wiil be discussed i' cretail i' chapter 4, EVieu,s also reports rhe ''ornralised.estriction', althor"rgh tl-ris can be ig'o'cd for. the tirne being si'ce it'rerely feports the regressron srope para'retc,r.(i' a differcnt folm) and its standar.cl err.or.
bacl< to the regression in re'ers (i.e. r,vith the r.arv pr.ices r.atirc' than tlte retr.rrns) and test the null hypothesis tl.rat 19 = 1 in this regr.ession. You should find in this case that the nLrll hypothesrs rs nor r.eiectecl (t:rble.
Tire test is performed in two different ways, but results suggest that the null hypothesis srrould creariy be rejected as trre p-value for the test is zero to four deci'ral praces. since we are testi'g a hypothesis about
))
This rvill create a new series named RSANDP that will contairl the returns of the S&P500. The operator (-1)is used to instrlrct EViews to use the onepcliod laggcd obsen,ation of the selies. To estimate percelttagc returns ol-r the Fold stoci<, pless the Genr button again and rype RFoRD=100-LOC(FoRD/FORD(
1))
Now go
bclow;.
This will yield a nerv selies named RFORD thrt will contain the reluurs of the Fold stocl{. EViews allorvs valious }<incls of tlansfolmrtions to the
se.r'ies. For
example
creares a new variable called X2
that is lialf
ofx
creates a new va|iable XSqthat is X squared creates a new varirble LX that is the log of X creates a new var-iable LAGX containing X lagged by one per.iod creates a new variable LAGX2 containing X lagged by two periods
the series appear to trtove togcthct'. l'o do this, cl'cate a new object b' clicking orl the Object/New Object ncnLr on thc mcllu bar-. Select Graph provide a nalte (call thc grapli Graphl) and thcrt in the new windov provide the nanres of the scrics to l)lot. Itt this :rew willdow type
I]RSANDP I]RFORD
l)
scLce
nshot 2.4
will
uppear.
LACX2=X(*2)
abs(X)
flrst difference of X rrth order difference of X first difference of the logarithm of X lth order differ-ence of the logarithnr of X
absoiute valr-te of X
If, in the transformation, the new series is given the sanle narne as tl.re old series, then the old series will be overwritten, Note that the retllrr-is
for the S&P index could have been constructed using a sin-rpler conmaud in the 'Genr'window such as
RSANDP= 100- DLOG(SANDP)
,1,10*!,,+-ui11.,]\
1"
I
as we used in chapter 1. Before we can transform the returns iDto excess returns, we need to be slightty careful because the stock returns
are monthly, but the Treasury bill yields are annualised. We could run the whole analysis using monthly data or using annualised data and it should not matter which rve use, but the two series rnust be rneasured consistently. So, to turn the T-bill yields into monthly figures and to write over the original series, press the Genr button again and type
USTB3lr{=USTB3M/12
ERSANDP
ERFORD
Now to compute the excess returns, click Genr again ancl type
ERSANDP=RSANDP-USTB3 l\{
where 'ERSANDP'will be used to denote the excess r.eturns, so that the original raw returns series will remain in the workfile. Tl-re Ford returns can simiiarly be transformed into a set of excess returns. Now tirat the excess returns have been obtained for. the fwo series. before rr,rnning the regression, plot the data to examine visually whethe|
This is a time-series plot of the fivo variables, but a scatter plot may Lr more informative. To examiue a scatter plot, Click Options, choose th Type tab, then select Scatte[ from the list and click OI(. There appears t be a weak association befween ERF-|AS and ERFORD. Close tl're windorv t the graph and return to the workfile window. To estimate the CAPM eqr-ration, click on Object/New Objects' In th nerv window, select Equation and nante the object CAPM, Click otl Ol ln thc window. spccifu the reglessiott eqr.ration. The lcg:'cssiott cqrt.tric takes the form
(R-.;ur
r'1),
tt -l ll(Rv
r'1)1
tr1
lntrodLtctory F.cotlometrics
fot' Iiinance
littcrl' tt'grcsston
ttloricl
81
Since the data have already been transfolnrecl to obtain the excess returns,
population coefficient is How coulcl the hypotiresrs that the value of, the eqlraltolbctestc(l?Thcanswet.istocljc]<orlView/CoefficierrtTestsilVald appeals' Type C(2)=1 - Coefficient Restrictions " rtncl thetr in tl.rc box that that thc CAPM beta of Fold The coucltrsiorl here is that tllc ntrll llypothe sis beta of 0 359 is not stock is 1 calillot bc t'elcctccl :ttrcl hcl'tcc thc cstinlatcd signilicrntly clitlctt'nt {tottr
Key concePts
To Lrse all the observatior-rs in the sanrple and to estirnate fhe regression using LS - Leasf Squarcs (NLS and ARMA), click on OK. The lesu]ts scLeen appears as in the followiug table. Mal<e sule that you save the Worl<file again to includc the transfonned sclies ancl lcglcssion leslrlts!
Dependent Variable: ERFORD
l'
nr.
fl'onr this cllapter are t *y tefn)s to be able to clcfinc ancl explain o resrcssion modcl a distLlrbancc terll'l ft populatioll
Coefficient
C
Std.
Error t-Statistic
ERSANDP
R-squared
2.09744s
22.05129
r\djusted R-squared
( F nf reorpssinn Surr squared resid Log likelihood
F-statisti c
-0.012989
22.79404
30047.09
9.0687s6
/)'value asymPtotic
e conslstclrcy * efficiency s statistical inlcrence '! altcrllative llypothesis r$ cotlfidence irlterval 4" relectlolt reglon {t lYPc II el'[ol' * po\4/cr of a test ri data trrinil)g
9.t36792
9.09ss14 1.785599
-283.6658
0.20s031 0.652297
PrnlrlF-ctrtistir\
Take a couple of minutes to examine the results of the regl-ession. \Mrat is the slope coefficient estimate and what does it signify? Is this coefficient statistically significant? The beta coefficient (tlie slope coefficient) estinrate
-\-r,,-u-d.t,tr /2
(24.1
is 0.3597. The 2-value of the r-ratio is 0.6523, signifying that the excess return on the narket proxy has no signiflcant explanatoly power for the variability of the excess returns of Ford stock. !\hat is the interpretation of the intercept estinate? Is it statistically significant? In fact, there is a considerably quickel method for using transformed variables in legression equations, and that is to write the tlansformation dilectly into the equatiou rvindow. In the CAPM example above, this cor-rld
hp dnrrp lrrr hrrrirro DLOG(FORD)-USTB3M C DLOG(SANDP)-USTB3M As well as being quicker'. an ildvantilgc of th js lpproach is that the outpUt will shorv n-rore clea|ly the leg|ession thrt has actr.rally been condncted, so that any errors in nraking the transfoluratiorrs
d' and 1i' to fii'rd the values of d rn' /. is differentiated w'r'l I that give the line that is closest to the clata' So The first derivatives at'' set to zel'o a and r4, ancl the first c-lerivatives are given by
;l/. _
jl;
_.fuI
1,, _o _ dr,r
rr
(24.,
(24.:
s Altlrorrglr the vlluc'0.159 ilnY scetlr a loilg rtry f)onl 1' cottsidt'rt'tl pttrc)y litrttt atr rlrd this llis lc(1 to r l'ttgc ecolometrjc Pc'rspcctlYc tllt'sinlPle sjze is quitc stllall l)()tll ll I : /J = {) iilld 31v61. rr'hich cxplains thc tlilure lo rciect l)lranrctcr rtina.ia
H,r:l=1.
-rf:
lntr o du ctory
Econonte tri c s
fctr r-inan c e
A brief oveniaw of the classicul linaor rtgrcssion ntodel s Derivation of the OLS standard error estimators f or the intercept and slope in the bivariate case Recall tltat the varirncc of the t';rtltlonl vat'irble ri can bc wt'itten rs
var-(r?)
The next step is to rearrange (2A.2) and (2A.3) in order to obtain expres_ sions for d and 1i. From (2A.2)
2A.2
T,r',-a-flt,1=o
Expandi'g the parentheses and .ecallirg that the sun runs so that there rvill be f ternrs in d
/_:
eA.4)
(24.1'
fron 1 to r
(2,4.s)
\-'.-r;-i\--, tu-t)/_\1=tl
f
.r',
{24.1(
But
ha and
Ir., = It,
By
so
it is possible to write
(2A.5) as
(2A.6;
as
var{ft: E(i-fllt
wolking first with (2A'17)'
the OLS c'stillator
(2A.1:
lcflliirrg
fJ
l'
i-d-p.i:0
From (2A.3)
(2A.t)
\'
I
(2A.t'
t,(.lr
- ri -
1ir,) =
(24.8)
* f,.t1{ tr,, atrd r"eplacing r with d + lli in (2A 18) r Il:,.tt, -,r -d.r, \-p) J L{.\,-\)=.: ij;\.i'
From (2A.7)
Aa:)._pir
v;rrtpr= u[ -
/\-r.r,-.tt(rr
(24.e)
r?
ft.r', -.tlr
1-\'\t - \
|
fiom
0
(2A.9)
(2,4.10)
r ',rt il) -
f.r,.r',
- i'+
i9.i
d',.r =
""''' -
..
"\I,.
,.1
- trf
{r,
* r)r
lLrt,
.it:\'
,r^
r,
I.,1, - r- f
Tr,,,
.., +
di
r,
d .
)-ri : o
L.t
(2/'.11,)
Rearrangtng
12A.12l (24.2
Rearranging for
,\Lt|
(24.13)
''u(p)
Now the
"t t\ :
f
terms in (2A.22)
rr,t .i
\24.2
will
cattcel to give
\24.2
\-",,-rl=Fl_r,
/,''l
Lincl
d=i-/lL
(24.14)
a)
Norv let -rf denote the mean-adjusted observ;rtion for.r-,, i.e. (.r, tion (2A.23) can be rvritten
_.r
). Equa-
li)t
'::-.
'2:e :')()l
()f
(21..24)
r:,rrfr:
(I '")-
-r(f,,,r,)i
-: \' )\:'i\ Trrrnilrg now to tl-re clelivatiorr of thc intercept rtaiC:'rc '::"": fz'tl fact nrrrclt rlo|e clifficult tlian tliat of the slope 'i'"nde:t '::": ":' '" ':t:f ():t botlr are very nrtch easiel ttsiltg nllltrix algebra ai :h"'"';-r \': "': "'':'?Ti:'''\ tlris clerivation will bc offc|ed in sr'tttrtllary form il )t ?()t''
d
as a
"::
: -]
(r.,')-
.,:(rr;.r'i *rr1.r..l
*...*r7..ri)l
121'.26\
l.r''"J :1"''
';i1t:'':rt
expcctations
it Fron
ty
=I
,r,
t, ,,,t
rl ) : Itil'1,,i1: 'rf ''
:.:, 'i)
: /-l=E(Ll.r'i:
(I.';')-
+ ..+ iri.ii: +
(2A.15),
t.ro.s.r-1trotlut.r.s)
rur'(rir=
(2A.27)
/r l.(f
Writing
(2A.34)
ivhere 'cross-products' in (2A.27) denotes all of tl.re rerms r/i-r.,:r/r.ri U + i). These cross-products can be written as i/i,/.ri.\; (l *.l) and tl.reir.expectation rvill be zero under the assun'lption that the error renns are uncorre. Iated \4/ith one another. Thus, the 'cross-products'term in (2A,27) will clrop out. Recall also from the chapter text that E(rri) is the error variance, rvhich is estimated using .sl
,,[r(t.,
)'
^I rrrlpy: **=
/)-..':)\Lt/
(.r:,rir +,r:.rl:
+ ..+.rr.i-i:)
el.z8)
r This looks rather colrplex, bllt fortullately, if rr'e iake the relnai:ling nunrer:' square brackets in the llulllerrtor, a lerln in the denominator to leave the required rc'ult
= _=
(I';')
as .f-
(.r
j:,
.r.':
*... +.ri:) :
.',IIi-' (r.,.')'
l2A.2eJ
A term i'f .rf: can be cancelled from the nur-nerator and denonrinrtor of (2A.29\, and recalling tl.rat .rf = (.r, - .i ), this sivcs rhe var.ia'cc of thc
slope coefficient
;. \ill'(F): \,,
Review questions
1. (a)
1,', 't
-._;
(2A.30)
points to the line rather than horizontal disia^ces: (b) Why are the vertical distances squared befc'e be'2 together?
'''--''
':-"
86
(c) Why are the squares of the vertical distances taken rather than the
absolute values? 2. Exprain, with the use of equations, the difference between the sampre regression function and the population regression functron. 3. What is an estimator? rs the oLS estimator superior to ail other estimators? Why or why not? 4. What five assunrptions are usually rnade about the unobservable error terms In the classical linear regression model (CLRM)? Briefly explain the meaning of each. Why are these assurlptions made? 5. Which of the following models can be estimated (followrng a suitable rearrangenler'rt if necessary) using ordinary least squares (oLS), where X, :, Z are variables and ct, p, ), are parameters to be estimated? (Htnt: the nrodels need to be linear in the paranreters.)
:-t
market, at the 5% tevel. Wriie down the null and alternative hypOthesis What do you conclude? Are the analyst's claims empirically verified? 7. The analyst also tells you that shares in Chris Mining PLC have no systematic risk, in other words that the returns on its shares are completely unrelatecl to movements in the market. The value of beta and its standard error are calculated to be 0,214 and 0.186' respectively. The model is estimated over 38 quarterly observatl0ns' Write down the null and alternative hypotheses Test this nuli hypothesis against a two-sided alternative. 8. Forrn and interpret a 95% and a 99% confidence Interval for beta usintr the figures given in questiorr 7. 9. Are hypotheses tested concerning the actual vaiues of the coefficients (i.e. 0) or their estimated values (i.e. /l r and why? 10. Using EViews, select one of the other stock series from the 'capm wkl
(2.57)
(2.58) (2.5e) (2.60)
fiIeandestimateaCAPMbetaforthatstock.Testthenu||hypothesis
that the true beta ls one and also test the null hypothesis that the tru(
alpha (intercept) is zero. What are your conclusions?
(2.6r)
E(R,): Rr + piLE(R.)
- Ril
(2.62)
usrng the standard notation. The first step in using the cApM is to estimate the stock's beta using the market model. The market model can be written as
R,,
= di
B; R,,,,
u,,
(2.63)
where R;, is the excess return for security i at time r, R,,,, is the excess return on a proxy for the market portfolio at time t , and u is an iid , random disturbance ternr. The cofficient beta in this case is arso the CAPM beta for security 1, suppose that you had estimated (2.63) and found that the estimated value of beta for a stock, f was 7.L47. The standard error associated with this coefficient SE{p) is estjlnated to be O.O548. A city analyst has told you that this security closely follows the market, but that it is no more risky, on average, than the nrarket. This can be tested by the nuli hypotheses that the value of ileta is one. The model is estimated over 62 daily observations. Test this hypothesis against a one-sided aiternative that the security is more risky than the