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Date: Sep 13, 2010

From: Dinesh Jayapathy

To: John Sparks

Regarding: Stock Investment Recommendation

I received your request for a recommendation regarding whether we should invest heavily
in stocks based on changes in the interest rate. I executed a regression analysis on the
data and based on the findings I recommend that we do not invest in stocks next year. I
have provided the analysis which supports the same.

Direction of Relationship


From the above figure, we can infer that the direction of relationship between
interest rate and stock return is negative. Also regression line in Fig.1 has a slope of
-0.57. If we assume that the interest rate will go down next year, then the negative slope
indicates that the stock returns will increase next year. Based on just this parameter, we
should invest in stocks, as the returns will be high.

Strength of relationship
The strength of the relationship can be explained by the r-squared value. The
scatterplot in the Fig.1 has r-squared values of 0.009 or approximately 1%. This means
that the value of stock return can be predicted only 1% accurately based on the interest
rate. This is a very low value and it indicates very weak relationship. Hence, we are not
confident in our prediction and should not proceed with the investment.

Residual Analysis


Residual Analysis can be done using the residual plot. The above figure shows the
residual plot for the given data. We can clearly see from the Fig.2 that there is no pattern
in the residuals. Since there is no increase or decrease in the spread about the line as the
Interest rate increases, the model predicts with equal accuracy across the entire range of
Interest rates.

The outliers can be easily identified using the Normal probability plot. From the
Normal probability plot, an outlier was identified at the top of the interest rate range at
14.72%. On leaving the outlier at interest rate = 14.72% and re-analyzing the data, the
following graph was obtained.

The removal of outlier didn’t change the strength of the relationship to a considerable
amount (new r-squared value = 0.001 or 0.1%). Also the nature of the relationship
remains negative, which is evident from the slope of -0.225. Hence we say that the outlier
has no significant effect of the strength or consistency of the relationship.

Based on the above analysis, even if the interest rates increase next year, due to
the very weak nature of the relationship we are not confident in our prediction. So my
recommendation is that we do not proceed with this investment. (Based on the
summary of the analysis I would recommend not to proceed with this investment as our
prediction is not completely guaranteed)