Financial Econometrics - Homework 2

Ngo Thien My - MAMAIU20013 & Phan Thi Thuy Trang - MAMAIU20049

Problem 2.

We have:
Population regression function (PRF): y = α + βx + ut
ˆ + ût
Sample regression function (SRF): ŷ = α̂ + βx

The key difference between PRF & SRF is that PRF represents the true underlying relationship
between the variables in the population, while SPF is an estimate of this relationship based on a
finite sample of data. Therefore, SPF is subject to sampling error, which means that it may not
perfectly capture the true relationship between the variables.

Problem 4.

Five assumptions are usually made about the unobservable error terms in CLRM:

(1) E(ut ) = 0: means that the errors have zero mean. This assumption ensures that the regression
line is the best fit for the data.

(2) V ar(ut ) = σ 2 < ∞: mean that the variance of the errors is constant and finite over all values
of xt . This assumption ensures that the residuals have the same amount of variation across the
entire range of the independent variable.

(3) cov(ui , uj ) = 0: mean that the errors are linearly independent of one another.This assumption
allows for the use of inferential statistics such as t-tests and confidence intervals

(4) cov(ut , xt ) = 0 mean that there is no relationship between the error and corresponding x
variate. This assumption ensures that the errors are not correlated with the independent variable
or with each other.

(5) ut ∼ N (0, σ 2 ) – i.e., that ut is normally distributed. This assumption ensures that the residuals
have the same spread across the entire range of the independent variable.

Problem 5.

1) yt = α + βxt + ut : This can be estimated by OLS as the parameters α and β are linear.

2) yt = eα .xt β .eut : This model can be estimated by OLS as the parameters are linear. Taking log
on both sides will have : ln(yt ) = α + βln(xt ) + ut which is linear in parameters.
3) yt = α + β.γxt + ut : This model is not linear in parameters as xt is multiplied by both β and
γ hence cannot be estimated by OLS
4) ln(yt ) = α + βln(xt ) + ut is linear in parameters hence can be estimated by OLS.

5) yt = α + βxt zt + ut : This model cannot be estimated by OLS. It is not linear in variable and
nor in parameter.

Problem 7.

We want to use a two-sided test to test the null hypothesis that shares in Chris Mining are com-
pletely unrelated to movements in the market as a whole. The null hypothesis would be that the
beta of Chris Mining plc is equal to zero. The alternative hypothesis would be that the beta is not
equal to zero.

H0 : β = 0
H1 : β ̸= 0
We have the test statistic:

β̂ − β ∗ 0.214 − 0
TS = = = 1.15054
SE(β̂) 0.186

Number of degrees of freedom: 38 - 2 = 36, then the critical value of 2 sides test is -2.024 and 2.2024.

Since our calculated t-value of 1.1505 falls within the range of -2.024 to +2.024, we fail to reject
the null hypothesis and conclude that there is insufficient evidence to suggest that the beta of
Chris Mining plc is different from zero.

Problem 6.

The equation that we estimate:

Rit = αi + βi .Rmt + uit
According to the requirement, we have the null hypothesis and alternative hypothesis are:

H0 : β = 1

H1 : β ̸= 1
We have the test statistic:

β̂ − β ∗ 1.147 − 1
TS = = ≈ 2.6825
SE(β̂) 0.0548

2
Number of degrees of freedom: 62 - 2 = 60, then the critical value of upper side is 1.6706.

Since our calculated t-value of 2.6825 > 1.6706, mean that it falls in the rejected region. Thus we
reject the null hypothesis and conclude that the risk of security is different from zero.

Thus, the analyst’s claims is not empirically verified.