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# Linear Regression with One Regressor

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## FRMFinancial Risk Manager

Regression Analysis
A regression analysis has the goal of measuring how changes in one variable,
called a dependent or explained variable can be explained by changes in one or
more other variables called the independent or explanatory variables. The
regression analysis measures the relationship by estimating an equation (e.g.,
linear regression model). The parameters of the equation indicate the
relationship.
A scatter plot is a visual representation of the relationship between the
dependent variable and a given independent variable. It uses a standard twodimensional graph where the values of the dependent, or Y variable, are on the
vertical axis, and those of the independent, or X variable, are on the horizontal
axis.

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Lockup(yrs)
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## Fugure 1:Hedge Fund Data

Returns(%) per year
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Average Return
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## Population Regression Function

E (return | lockup period) = B0 + B1 (lockup period)
Or more generally:

## E (Yi | Xi) = B0 + B1 (Xi)

Intercept Coefficient

Slope Coefficient

Yi B0 B1 X i i
Error Term

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## Sample Regression Function and Ordinary least squares (OLS)

Yi b0 b1 X i ei
minimize e Yi - (b0 b1 Xi )

2
i

Yi b0 b1X i ei

e4

e2

e1

e3

Yi b0 b1X i
X

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201405

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## FRMFinancial Risk Manager

201405
48. You are conducting an ordinary least squares regression of the returns on stocks Y
and X as Y=a + b X + based on the past three years daily adjusted closing price
data. Prior to conducting the regression, you calculated the following information
from the data:
Sample covariance
Sample Variance of Stock X
Sample Variance of Stock Y
Sample mean return of stock X

0.000181
0.000308
0.000525
-0.03%

0.03%

A. 0.35
B. 0.45
C. 0.59
D. 0.77

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Notes 128

0.000181
0.5877
0.000308

Example

## Consider two stocks, A and B. Assume their annual returns are

jointly normally distributed, the marginal distribution of each stock
has mean 2% and standard deviation 10%, and the correlation is
0.9. What is the expected annual return of stock A if the annual
return of stock B is 3%?
A.
B.
C.
D.

2%
2.9%
4.7%
1.1%

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## Assumptions Underlying Linear Regression

Linear regression requires a number of assumptions. Most of the major assumptions
pertain to she regression models residual term (i.e., error term). Three key assumptions
are as follows:
1. The expected value of the error term, conditional on the independent variable, is
zero ( E ( i | X i ) 0 )
2. All (X, Y) observations are independently and identically distributed (i.i.d.).
3. It is unlikely that large outliers will be observed in the data. Large outliers have the
potential to create misleading regression results.
4. A linear relationship exists between the dependent and independent variable.
5. The model is correctly specified in that it includes the appropriate independent
variable and does not omit variables.
6. The independent variable is uncorrelated with the error terms.
7. The variance of i is constant for all Xi : Var( i | X i ) 2
8. No serial correlation of the error terms exists

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Y

Yi b0 b1 X i

(Yi Yi ) SSR
__

(Yi Y ) TSS

(Yi Y ) ESS

__

Y
b0

(Y
TSS

__

Y)

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__

(Y Y )

ESS

ESS
SSR
R
1
TSS
TSS
2

(Y Y )
i

SSR

2 R2 R2

## The Standard Error of the Regression

The standard error of the regression (SER) measures the degree of variability
of the actual Y-values relative to the estimated Y-values from a regression
equation. The SER gauges the "fit" of the regression line. The smaller the
standard error, the better the fit.
The SER is the standard deviation of the error terms in the regression. As such,
SER is also referred to as the standard error of the residual, or the standard error
of estimate (SEE).
In some regressions, the relationship between the independent and dependent
variables is very strong (e.g., the relationship between 10-year Treasury bond
yields and mortgage rates). In other cases, the relationship is much weaker (e.g.,
the relationship between stock returns and inflation). SER will be low (relative to
total variability) if the relationship is very strong and high if the relationship is
weak.
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FRM

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