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FIN 235-A Advanced Statistical Modeling in Finance

Homework Assignment 1 (Practice)

1. The single-index model (SIM) is possibly the simplest asset pricing model that we use in
finance to measure the tradeoff between the systematic risk and return of a stock. Mathe-
matically the SIM could be expressed as

rit − rf = αi + βi (rmt − rf ) + ϵit (1)

where rit is the (simple) return for security i at time t, rmt is the return on a proxy for the
market portfolio at time t, and ϵit is a random disturbance term. The coefficient βi measures
the systematic risk a firm i is facing.

(a) Using the notation above, please write out the expression of Capital Asset Pricing Model
(CAPM).

Solutions:

E(rit ) − rf = βi (E(rmt ) − rf ) (2)

(b) In the SIM expression, parameters αi and βi could be estimated using financial data.
Using the data in the “HW1CAPM.xlsx” file, please first draw a scatter plot of excess
stock return against excess market return in Excel. (Note: You need to put excess stock
return on the vertical axis and excess market return on the horizontal axis. Crop the
Excel scatter plot and paste it below.)

Solutions:
(Omitted.)

(c) Estimate αi and βi via OLS regression in Excel using the data in “HW1CAPM.xlsx”.
(Note: Crop the Excel regression output and paste it below.)

Solutions:
(Omitted.)

(d) Explain the estimated αi and βi in words.

Solutions:
αi : When excess market return is zero, ceteris parabus, the mean excess stock return
will be the estimated αi .
βi : When excess market return increases by 1%, ceteris parabus, the mean excess stock
return will increase by βi %.

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(e) Using the variables in the SIM expression above, please state the four assumptions that
we require to make the OLS regression BLUE.

Solutions:
Zero error term mean:E(ϵit ) = 0.
Homoskedasticity: var(ϵit ) = σi2 .
Serial uncorrelation: cov(ϵit , ϵis ) = 0, ∀t ̸= s.
Exogeneity: cov(rmt , ϵit ) = 0.

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2. Suppose that you had estimated the market model and found that the estimated value of beta
for a stock, the estimated beta was 1.547. The standard error associated with this coefficient
is estimated to be 0.325.
A city analyst has told you that this security closely follows that market but that it is no more
risky, on average, than the market. This can be tested by the null hypothesis that the value
of beta is one. The mode is estimated over sixty-two daily observations. Test this hypothesis
against a one-sided alternative that the security is more risky than the market, at the 5%
level.
Write down the null and alternative hypothesis. What do you conclude? Are the analyst’s
claims empirically verified?

Solutions:
The null hypothesis is that the true (but unknown) value of beta is equal to one, against a
one sided alternative that it is greater than one:

H0 : β = 1;

H1 : β > 1
The test statistic is given by

β̂ − β ∗ 1.547 − 1
test stat. = = = 1.68.
s.e.(β̂) 0.325

We want to compare this with a value from the t-table with T-2 degrees of freedom, where T is
the sample size, and here T-2 =60. We want a value with 5% all in one tail since we are doing
a 1-sided test. The critical t-value from the t-table is 1.671. The value of the test statistic
is in the rejection region and hence we can reject the null hypothesis. We have statistically
significant evidence that this security has a beta greater than one, i.e. it is significantly more
risky than the market as a whole.

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3. The analyst also tells that shares in Chris Mining plc have no systematic risk. In other words,
that the returns on its shares are completely unrelated to movements in the market. The
value of beta and its standard error are calculated to be 0.325 and 0.145, respectively. The
model is estimated over 38 quarterly observations.
Write down the null and alternative hypothesis. Test this null hypothesis against a two-sided
alternatives at 5% significance level.

Solutions:
We want to use a two-sided test to test the null hypothesis that shares in Chris Mining are
completely unrelated to movements in the market as a whole. In other words, the value of
beta in the regression model would be zero so that whatever happens to the value of the
market proxy, Chris Mining would be completely unaffected by it.
The null and alternative hypotheses are therefore:

H0 : β = 0;

H1 : β ̸= 0
The test statistic has the same format as before, and is given by:

β̂ − β ∗ 0.325 − 0
test stat. = = = 2.24.
s.e.(β̂) 0.145

We want to find a value from the t-tables for a variable with 38-2=36 degrees of freedom,
and we want to look up the value that puts 2.5% of the distribution in each tail since we are
doing a two-sided test and we want to have a 5% size of test over all. The critical t-value
is therefore ±2.03. Since the test statistic is within the rejection region, we reject the null
hypothesis.

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4. Which of the following hypotheses about the coefficients can be tested using a t-test? Which
of them can be tested using an F-test? In each case, state the number of restrictions.
(a) H0 : β3 = 2
(b) H0 : β3 + β4 = 1
(c) H0 : β3 + β4 = 1 and β5 = 1
(d) H0 : β2 = 0 and β3 = 0 and β4 = 0 and β5 = 0

Solutions:
(a) H0 : β3 = 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 : β3 + β4 = 1
Since this involves more than one coefficient, we should use an F-test. There is one restriction.
(c) H0 : β3 + β4 = 1 and β5 = 1
Since we are testing more than one hypothesis simultaneously, we would use an F-test. There
are 2 restrictions.
(d) H0 : β2 = 0 and β3 = 0 and β4 = 0 and β5 = 0
As for (c), we are testing multiple hypotheses so we cannot use a t-test. We have 4 restrictions.

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5. Suppose a researcher wants to test whether the returns on a company stock (y) is correlated
to two factors (factor x2 and factor x3 ) among four considered. The regression is carried out
on 124 monthly observations. The regression is

yt = β1 + β2 x2t + β3 x3t + β4 x4t + β5 x5t + ut

(a) Write out the restricted and unrestricted regression equations.

(b) If the two RSS are 300 and 450, perform the test at 5% level.
Note: F(2,119) = 3.00 (5% level), F(3,119) = 2.68 (5% level), F(2,119) = 4.79 (1% level),
and F(3,119) = 3.95 (1% level).

Solutions:

(a) H0 : β2 = 0 and β3 = 0.
The unrestricted regression is the one in the question.
The restricted regression is yt = β1 + β4 x4t + β5 x5t + ut .
(b) In the F-test formula, T=124, k=5, m=2, RRSS=450, URSS=300
F-test statistic = 29.75 > 3.00.
Reject.