Introductory Econometrics for Finance

Chris Brooks
Solutions to Review Questions - Chapter 5

1. In the same way as we make assumptions about the true value of beta and not the
estimated values, we make assumptions about the true unobservable disturbance
terms rather than their estimated counterparts, the residuals.

We know the exact value of the residuals, since they are defined by uˆ t  y t  yˆ t . So
we do not need to make any assumptions about the residuals since we already know
their value. We make assumptions about the unobservable error terms since it is
always the true value of the population disturbances that we are really interested in,
although we never actually know what these are.

2. We would like to see no pattern in the residual plot! If there is a pattern in the
residual plot, this is an indication that there is still some “action” or variability left in
yt that has not been explained by our model. This indicates that potentially it may be
possible to form a better model, perhaps using additional or completely different
explanatory variables, or by using lags of either the dependent or of one or more of
the explanatory variables. Recall that the two plots shown on pages 157 and 159,
where the residuals followed a cyclical pattern, and when they followed an
alternating pattern are used as indications that the residuals are positively and
negatively autocorrelated respectively.

Another problem if there is a “pattern” in the residuals is that, if it does indicate the
presence of autocorrelation, then this may suggest that our standard error estimates
for the coefficients could be wrong and hence any inferences we make about the
coefficients could be misleading.

3. The t-ratios for the coefficients in this model are given in the third row after the
standard errors. They are calculated by dividing the individual coefficients by their
standard errors.

ŷt = 0.638 + 0.402 x2t - 0.891 x3t R 2 0.96,R 2 0.89

(0.436) (0.291) (0.763)
t-ratios 1.46 1.38 -1.17

The problem appears to be that the regression parameters are all individually
insignificant (i.e. not significantly different from zero), although the value of R2 and its

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adjusted version are both very high, so that the regression taken as a whole seems to
indicate a good fit. This looks like a classic example of what we term near
multicollinearity. This is where the individual regressors are very closely related, so
that it becomes difficult to disentangle the effect of each individual variable upon the
dependent variable.

The solution to near multicollinearity that is usually suggested is that since the
problem is really one of insufficient information in the sample to determine each of
the coefficients, then one should go out and get more data. In other words, we
should switch to a higher frequency of data for analysis (e.g. weekly instead of
monthly, monthly instead of quarterly etc.). An alternative is also to get more data by
using a longer sample period (i.e. one going further back in time), or to combine the
two independent variables in a ratio (e.g. x2t / x3t ).

Other, more ad hoc methods for dealing with the possible existence of near
multicollinearity were discussed in Chapter 5:
- Ignore it: if the model is otherwise adequate, i.e. statistically and in terms of each
coefficient being of a plausible magnitude and having an appropriate sign.
Sometimes, the existence of multicollinearity does not reduce the t-ratios on
variables that would have been significant without the multicollinearity
sufficiently to make them insignificant. It is worth stating that the presence of
near multicollinearity does not affect the BLUE properties of the OLS estimator –
i.e. it will still be consistent, unbiased and efficient since the presence of near
multicollinearity does not violate any of the CLRM assumptions 1-4. However, in
the presence of near multicollinearity, it will be hard to obtain small standard
errors. This will not matter if the aim of the model-building exercise is to produce
forecasts from the estimated model, since the forecasts will be unaffected by the
presence of near multicollinearity so long as this relationship between the
explanatory variables continues to hold over the forecasted sample.
- Drop one of the collinear variables - so that the problem disappears. However,
this may be unacceptable to the researcher if there were strong a priori
theoretical reasons for including both variables in the model. Also, if the removed
variable was relevant in the data generating process for y, an omitted variable
bias would result.
- Transform the highly correlated variables into a ratio and include only the ratio
and not the individual variables in the regression. Again, this may be
unacceptable if financial theory suggests that changes in the dependent variable
should occur following changes in the individual explanatory variables, and not a
ratio of them.

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4. (a) The assumption of homoscedasticity is that the variance of the errors is

constant and finite over time. Technically, we write Var (u t )  u2 .

(b) The coefficient estimates would still be the “correct” ones (assuming that
the other assumptions required to demonstrate OLS optimality are satisfied),
but the problem would be that the standard errors could be wrong. Hence if
we were trying to test hypotheses about the true parameter values, we could
end up drawing the wrong conclusions. In fact, for all of the variables except
the constant, the standard errors would typically be too small, so that we
would end up rejecting the null hypothesis too many times.

(c) There are a number of ways to proceed in practice, including

- Using heteroscedasticity robust standard errors which correct for the problem by
enlarging the standard errors relative to what they would have been for the situation
where the error variance is positively related to one of the explanatory variables.
- Transforming the data into logs, which has the effect of reducing the effect of large
errors relative to small ones.

5. (a) This is where there is a relationship between the ith and jth residuals.
Recall that one of the assumptions of the CLRM was that such a relationship
did not exist. We want our residuals to be random, and if there is evidence of
autocorrelation in the residuals, then it implies that we could predict the sign
of the next residual and get the right answer more than half the time on
average!

(b) The Durbin Watson test is a test for first order autocorrelation. The test is
calculated as follows. You would run whatever regression you were interested
in, and obtain the residuals. Then calculate the statistic
T

  uˆ  uˆt  1 
2
t
DW t 2 T
2
 uˆ
t 2
t

You would then need to look up the two critical values from the Durbin
Watson tables, and these would depend on how many variables and how
many observations and how many regressors (excluding the constant this
time) you had in the model.
The rejection / non-rejection rule would be given by selecting the appropriate
region from the following diagram:

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(c) We have 60 observations, and the number of regressors excluding the

constant term is 3. The appropriate lower and upper limits are 1.48 and 1.69
respectively, so the Durbin Watson is lower than the lower limit. It is thus
clear that we reject the null hypothesis of no autocorrelation. So it looks like
the residuals are positively autocorrelated.

(d) y t  1   2 x 2t   3 x3t   4 x 4t  u t
The problem with a model entirely in first differences, is that once we
calculate the long run solution, all the first difference terms drop out (as in the
long run we assume that the values of all variables have converged on their
own long run values so that yt = yt-1 etc.) Thus when we try to calculate the
long run solution to this model, we cannot do it because there isn’t a long run
solution to this model!

(e) y t  1   2 x 2t   3 x3t   4 x 4t   5 x 2t  1   6 X 3t  1   7 X 4t  1  vt
The answer is yes, there is no reason why we cannot use Durbin Watson in
this case. You may have said no here because there are lagged values of the
regressors (the x variables) variables in the regression. In fact this would be
wrong since there are no lags of the DEPENDENT (y) variable and hence DW
can still be used.

6. y t  1   2 x 2t   3 x 3t   4 y t  1   5 x 2t  1   6 x 3t  1   7 x rt  4  u t
The major steps involved in calculating the long run solution are to
- set the disturbance term equal to its expected value of zero
- drop the time subscripts
- remove all difference terms altogether since these will all be zero by the definition
of the long run in this context.

Following these steps, we obtain

0  1   4 y   5 x 2   6 x 3   7 x 3
We now want to rearrange this to have all the terms in x2 together and so that y is
the subject of the formula:

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 4 y   1   5 x 2   6 x3   7 x3
 4 y   1   5 x 2  (  6   7 ) x3
 5 ( 6   4 )
y  1  x2  x3
4 4 4
The last equation above is the long run solution.

7. Ramsey’s RESET test is a test of whether the functional form of the regression is
appropriate. In other words, we test whether the relationship between the
dependent variable and the independent variables really should be linear or whether
a non-linear form would be more appropriate. The test works by adding powers of
the fitted values from the regression into a second regression. If the appropriate
model was a linear one, then the powers of the fitted values would not be significant
in this second regression.

If we fail Ramsey’s RESET test, then the easiest “solution” is probably to transform all
of the variables into logarithms. This has the effect of turning a multiplicative model
into an additive one.

If this still fails, then we really have to admit that the relationship between the
dependent variable and the independent variables was probably not linear after all so
that we have to either estimate a non-linear model for the data (which is beyond the
scope of this course) or we have to go back to the drawing board and run a different
regression containing different variables.

8. (a) It is important to note that we did not need to assume normality in order
to derive the sample estimates of  and  or in calculating their standard
errors. We needed the normality assumption at the later stage when we
come to test hypotheses about the regression coefficients, either singly or
jointly, so that the test statistics we calculate would indeed have the
distribution (t or F) that we said they would.

(b) One solution would be to use a technique for estimation and inference
which did not require normality. But these techniques are often highly
complex and also their properties are not so well understood, so we do not
know with such certainty how well the methods will perform in different
circumstances.

One pragmatic approach to failing the normality test is to plot the estimated
residuals of the model, and look for one or more very extreme outliers. These
would be residuals that are much “bigger” (either very big and positive, or
very big and negative) than the rest. It is, fortunately for us, often the case

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that one or two very extreme outliers will cause a violation of the normality
assumption. The reason that one or two extreme outliers can cause a
violation of the normality assumption is that they would lead the (absolute
value of the) skewness and / or kurtosis estimates to be very large.

Once we spot a few extreme residuals, we should look at the dates when
these outliers occurred. If we have a good theoretical reason for doing so, we
can add in separate dummy variables for big outliers caused by, for example,
wars, changes of government, stock market crashes, changes in market
microstructure (e.g. the “big bang” of 1986). The effect of the dummy variable
is exactly the same as if we had removed the observation from the sample
altogether and estimated the regression on the remainder. If we only remove
observations in this way, then we make sure that we do not lose any useful
pieces of information represented by sample points.

9. (a) Parameter structural stability refers to whether the coefficient estimates

for a regression equation are stable over time. If the regression is not
structurally stable, it implies that the coefficient estimates would be different
for some sub-samples of the data compared to others. This is clearly not what
we want to find since when we estimate a regression, we are implicitly
assuming that the regression parameters are constant over the entire sample
period under consideration.

(b) 1981M1-1995M12
rt = 0.0215 + 1.491 rmt RSS=0.189 T=180
1981M1-1987M10
rt = 0.0163 + 1.308 rmt RSS=0.079 T=82
1987M11-1995M12
rt = 0.0360 + 1.613 rmt RSS=0.082 T=98

(c) If we define the coefficient estimates for the first and second halves of the
sample as 1 and 1, and 2 and 2 respectively, then the null and alternative
hypotheses are
H0 : 1 = 2 and 1 = 2

and H1 : 1  2 or 1  2

(d) The test statistic is calculated as

Test stat. =

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RSS  ( RSS1  RSS 2 ) (T  2k ) 0.189  (0.079  0.082) 180  4

*  * 15.304
RSS1  RSS 2 k 0.079  0.082 2

This follows an F distribution with (k,T-2k) degrees of freedom. F(2,176) = 3.05

at the 5% level. Clearly we reject the null hypothesis that the coefficients are
equal in the two sub-periods.

10. The data we have are

1981M1-1995M12
rt = 0.0215 + 1.491 Rmt RSS=0.189 T=180
1981M1-1994M12
rt = 0.0212 + 1.478 Rmt RSS=0.148 T=168
1982M1-1995M12
rt = 0.0217 + 1.523 Rmt RSS=0.182 T=168
First, the forward predictive failure test - i.e. we are trying to see if the model for
1981M1-1994M12 can predict 1995M1-1995M12.
The test statistic is given by
RSS  RSS1 T1  k 0.189  0.148 168  2
*  * 3.832
RSS1 T2 0.148 12
Where T1 is the number of observations in the first period (i.e. the period that we
actually estimate the model over), and T2 is the number of observations we are trying
to “predict”. The test statistic follows an F-distribution with (T2, T1-k) degrees of
freedom. F(12, 166) = 1.81 at the 5% level. So we reject the null hypothesis that the
model can predict the observations for 1995. We would conclude that our model is
no use for predicting this period, and from a practical point of view, we would have to
consider whether this failure is a result of a-typical behaviour of the series out-of-
sample (i.e. during 1995), or whether it results from a genuine deficiency in the
model.

The backward predictive failure test is a little more difficult to understand, although
no more difficult to implement. The test statistic is given by
RSS  RSS1 T1  k 0.189  0.182 168  2
*  * 0.532
RSS1 T2 0.182 12
Now we need to be a little careful in our interpretation of what exactly are the “first”
and “second” sample periods. It would be possible to define T1 as always being the
first sample period. But I think it easier to say that T1 is always the sample over which
we estimate the model (even though it now comes after the hold-out-sample). Thus
T2 is still the sample that we are trying to predict, even though it comes first. You can
use either notation, but you need to be clear and consistent. If you wanted to choose
the other way to the one I suggest, then you would need to change the subscript 1

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everywhere in the formula above so that it was 2, and change every 2 so that it was a
1.

Either way, we conclude that there is little evidence against the null hypothesis. Thus
our model is able to adequately back-cast the first 12 observations of the sample.

11. By definition, variables having associated parameters that are not significantly
different from zero are not, from a statistical perspective, helping to explain
variations in the dependent variable about its mean value. One could therefore argue
that empirically, they serve no purpose in the fitted regression model. But leaving
such variables in the model will use up valuable degrees of freedom, implying that
the standard errors on all of the other parameters in the regression model, will be
unnecessarily higher as a result. If the number of degrees of freedom is relatively
small, then saving a couple by deleting two variables with insignificant parameters
could be useful. On the other hand, if the number of degrees of freedom is already
very large, the impact of these additional irrelevant variables on the others is likely to
be inconsequential.

12. An outlier dummy variable will take the value one for one observation in the
sample and zero for all others. The Chow test involves splitting the sample into two
parts. If we then try to run the regression on both the sub-parts but the model
contains such an outlier dummy, then the observations on that dummy will be zero
everywhere for one of the regressions. For that sub-sample, the outlier dummy
would show perfect multicollinearity with the intercept and therefore the model
could not be estimated.

14. (a) The term ‘measurement error’ simply refers to the situation where one of
the variables in a regression model contains some sort of inaccuracy, also
known as the errors-in-variables problem.

(b) Measurement error has a variety of possible causes. As a first example,

most macroeconomic and company account variables can be constructed
precisely – they must be estimated (GDP, unemployment, general price
levels, a firm’s inventory levels, and so on). Second, numerous models in
finance involve expectations, but these cannot be directly observed and so a
proxy for them must be used – for example, we might assume a previous
average of inflation to be the value that consumers expect in the future.
Similarly, volatilities and betas in the CAPM cannot be directly observed and
must be estimated.

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(c) Measurement error is only really an issue if it is present in the

independent variables of a regression. There, is causes those variables to be
stochastic, thus violating the assumption that they are not, which in turn will
cause parameter estimation to lose consistency. Measurement error in the
explained variable is much less serious, however, since it will be captured by
the disturbance term in the regression model. Thus, when the explained
variable is measured with error, the disturbance term will in effect be a
composite of the usual disturbance term and another source of noise from
the measurement error. In such circumstances, the parameter estimates will
still be consistent
and unbiased and the usual formulae for calculating standard errors will still
be appropriate. The only consequence is that the additional noise means the
standard errors will be enlarged relative to the situation where there was no
measurement error in y.

(d) The impact of this estimation bias when the explanatory variables are
measured with error can be quite important when testing the CAPM since the
betas employed in the Fama-MacBeth approach are estimated (with error) in
a first stage and then constitute explanatory variables in a set of second stage
cross-sectional regressions. In the finance literature, the effect of this has
sometimes been termed attenuation bias. Early tests of the CAPM showed
that the relationship between beta and returns was positive but smaller than
expected, and this is precisely what would happen as a result of
measurement error in the betas. Various approaches to solving this issue
have been proposed, the most common of which is to use portfolio betas in
place of individual stock betas in the second stage. The hope is that this will
smooth out the estimation error in the betas. An alternative approach
attributed to Shanken (1992) is to modify the standard errors in the second
stage regression to adjust directly for the measurement errors in the betas.