Introductory Econometrics for Finance

Chris Brooks
Solutions to Review Questions - Chapter 4

1. It can be proved that a t-distribution is just a special case of the more general F-
distribution. The square of a t-distribution with T-k degrees of freedom will be
identical to an F-distribution with (1,T-k) degrees of freedom. But remember that if
we use a 5% size of test, we will look up a 5% value for the F-distribution because the
test is 2-sided even though we only look in one tail of the distribution. We look up a
2.5% value for the t-distribution since the test is 2-tailed.

Examples at the 5% level from tables

T-k F critical value t critical value

20 4.35 2.09
40 4.08 2.02
60 4.00 2.00
120 3.92 1.98

2. (a) H0 : 3 = 2
We could use an F- or a t- test for this one since it is a single hypothesis involving only
one coefficient. We would probably in practice use a t-test since it is computationally
simpler and we only have to estimate one regression. There is one restriction.
(b) H0 : 3 + 4 = 1
Since this involves more than one coefficient, we should use an F-test. There is one
restriction.
(c) H0 : 3 + 4 = 1 and 5 = 1
Since we are testing more than one hypothesis simultaneously, we would use an F-
test. There are 2 restrictions.
(d) H0 : 2 =0 and 3 = 0 and 4 = 0 and 5 = 0
As for (c), we are testing multiple hypotheses so we cannot use a t-test. We have 4
restrictions.
(e) H0 : 23 = 1
Although there is only one restriction, it is a multiplicative restriction. We therefore
cannot use a t-test or an F-test to test it. In fact we cannot test it at all using the
methodology that has been examined in this chapter.

3. THE regression F-statistic would be given by the test statistic associated with
hypothesis iv) above. We are always interested in testing this hypothesis since it

1
Introductory Econometrics for Finance by Chris Brooks

tests whether all of the coefficients in the regression (except the constant) are jointly
insignificant. If they are then we have a completely useless regression, where none of
the variables that we have said influence y actually do. So we would need to go back
to the drawing board!

The alternative hypothesis is:

H1 : 2  0 or 3  0 or 4  0 or 5  0
Note the form of the alternative hypothesis: “or” indicates that only one of the
components of the null hypothesis would have to be rejected for us to reject the null
hypothesis as a whole.

4. The restricted residual sum of squares will always be at least as big as the
unrestricted residual sum of squares i.e.
RRSS  URSS
To see this, think about what we were doing when we determined what the
regression parameters should be: we chose the values that minimised the residual
sum of squares. We said that OLS would provide the “best” parameter values given
the actual sample data. Now when we impose some restrictions on the model, so
that they cannot all be freely determined, then the model should not fit as well as it
did before. Hence the residual sum of squares must be higher once we have imposed
the restrictions; otherwise, the parameter values that OLS chose originally without
the restrictions could not be the best.

In the extreme case (very unlikely in practice), the two sets of residual sum of
squares could be identical if the restrictions were already present in the data, so that
imposing them on the model would yield no penalty in terms of loss of fit.

5. The null hypothesis is: H0 : 3 + 4 = 1 and 5 = 1

The first step is to impose this on the regression model:
yt = 1 + 2x2t + 3x3t + 4x4t + 5x5t + ut subject to 3 + 4 = 1 and 5 = 1.
We can rewrite the first part of the restriction as 4 = 1 - 3
Then rewrite the regression with the restriction imposed
yt = 1 + 2x2t + 3x3t + (1-3)x4t + x5t + ut
which can be re-written
yt = 1 + 2x2t + 3x3t + x4t - 3x4t + x5t + ut
and rearranging
(yt – x4t – x5t ) = 1 + 2x2t + 3x3t - 3x4t + ut

(yt – x4t – x5t) = 1 + 2x2t + 3(x3t –x4t)+ ut

Now create two new variables, call them Pt and Qt:

2
Introductory Econometrics for Finance by Chris Brooks

pt = (yt - x3t - x4t)

qt = (x2t -x3t)
We can then run the linear regression:
pt = 1 + 2x2t + 3qt+ ut ,
which constitutes the restricted regression model.

The test statistic is calculated as ((RRSS-URSS)/URSS)*(T-k)/m

In this case, m=2, T=96, k=5 so the test statistic = 5.704. Compare this to an F-
distribution with (2,91) degrees of freedom, which is approximately 3.10. Hence we
reject the null hypothesis that the restrictions are valid. We cannot impose these
restrictions on the data without a substantial increase in the residual sum of squares.

6. ri = 0.080 + 0.801Si + 0.321MBi + 0.164PEi - 0.084BETAi

(0.064) (0.147) (0.136) (0.420) (0.120)
1.25 5.45 2.36 0.390 -0.700

The t-ratios are given in the final row above, and are in italics. They are calculated by
dividing the coefficient estimate by its standard error. The relevant value from the t-
tables is for a 2-sided test with 5% rejection overall. T-k = 195; tcrit = 1.97. The null
hypothesis is rejected at the 5% level if the absolute value of the test statistic is
greater than the critical value. We would conclude based on this evidence that only
firm size and market to book value have a significant effect on stock returns.

If a stock’s beta increases from 1 to 1.2, then we would expect the return on the
stock to FALL by (1.2-1)*0.084 = 0.0168 = 1.68%
This is not the sign we would have expected on beta, since beta would be expected
to be positively related to return, since investors would require higher returns as
compensation for bearing higher market risk.

We would thus consider deleting the price/earnings and beta variables from the
regression since these are not significant in the regression - i.e. they are not helping
much to explain variations in y. We would not delete the constant term from the
regression even though it is insignificant since there are good statistical reasons for
its inclusion.

7. y t  1   2 x 2t   3 x 3t   4 y t  1  u t
y t 1   2 x 2t   3 x 3t   4 y t  1  v t .

Note that we have not changed anything substantial between these models in the
sense that the second model is just a re-parameterisation (rearrangement) of the
first, where we have subtracted yt-1 from both sides of the equation.

3
Introductory Econometrics for Finance by Chris Brooks

(a) Remember that the residual sum of squares is the sum of each of the
squared residuals. So lets consider what the residuals will be in each case. For
the first model in the level of y
uˆ t  y t  yˆ t  y t  ˆ1  ˆ 2 x 2t  ˆ 3 X 3t  ˆ 4 y t  1
Now for the second model, the dependent variable is now the change in y:
vˆt y t  yˆ t y t  ˆ1  ˆ 2 x 2t  ˆ 3 x 3t  ˆ 4 y t  1
where y  is the fitted value in each case (note that we do not need at this
stage to assume they are the same). Rearranging this second model would
give:
uˆ t  y t  y t  1  ˆ1  ˆ 2 x 2 t  ˆ 3 x 3t  ˆ 4 y t  1
 y t  ˆ1  ˆ 2 x 2t  ˆ 3 x 3t  (ˆ 4  1) y t  1
If we compare this formulation with the one we calculated for the first model,
we can see that the residuals are exactly the same for the two models, with
ˆ 4 ˆ 4  1 and ˆ i ˆ i (i = 1, 2, 3). Hence if the residuals are the same, the
residual sum of squares must also be the same. In fact the two models are
really identical, since one is just a rearrangement of the other.

(b) As for R2, recall how we calculate R2:

RSS
R 2 1  for the first model and
 ( yi  y ) 2
RSS
R 2 1  in the second case. Therefore since the total sum of
 (y i  y ) 2
squares (the denominator) has changed, then the value of R2 must have also
changed as a consequence of changing the dependent variable.

(c) By the same logic, since the value of the adjusted R2 is just an algebraic
modification of R2 itself, the value of the adjusted R2 must also change.

8. A researcher estimates the following two econometric models

y t   1   2 x 2 t   3 x 3t  u t
y t  1   2 x 2 t   3 x 3t   4 x 4 t  v t
(a) The value of R2 will almost always be higher for the second model since it
has another variable added to the regression. The value of R2 would only be
identical for the two models in the very, very unlikely event that the
estimated coefficient on the x4t variable was exactly zero. Otherwise, the R2
must be higher for the second model than the first.

4
Introductory Econometrics for Finance by Chris Brooks

(b) The value of the adjusted R2 could fall as we add another variable. The
reason for this is that the adjusted version of R2 has a correction for the loss
of degrees of freedom associated with adding another regressor into a
regression. This implies a penalty term, so that the value of the adjusted R2
will only rise if the increase in this penalty is more than outweighed by the
rise in the value of R2.

11. R2 may be defined in various ways, but the most common is

ESS
R2 
TSS
Since both ESS and TSS will have units of the square of the dependent variable, the
units will cancel out and hence R2 will be unit-free!

12. Quantile regressions represent a comprehensive way to analyse the relationships

between a set of variables that involves constructing a family of regression models,
each for different quantiles of the distribution of the dependent variable. Standard
regression models effectively examine the relationship between a set of variables
evaluated at the means of those variables whereas quantile regressions allow us to
potentially examine the relationship between the variables across the whole of their
distributions. They are far more robust to outliers and non-normality than OLS
regressions in the same fashion that the median is often a better measure of average
or ‘typical’ behaviour than the mean when the distribution is considerably skewed by
a few large outliers. Quantile regression is a non-parametric technique since no
distributional assumptions are required to optimally estimate the parameters.

13. No, this would not be a good way to proceed. By removing part of the sample in
this way, effectively the researcher has truncated the sample, and the remaining part
would suffer from severe selection biases. The results from this estimation would be
at best very misleading. Using a quantile regression would probably do the job that
the researcher wanted in a much more valid way and would not in fact involve using
a sub-sample since all of the data are used in estimating all of the quantiles.