ECM1002- Econometrics

Workshop - Week 4
You are required to study Lecture notes – Week 04 prior to attending this workshop.

After attending this workshop, you would be able to:

- Understand hypothesis testing and statistical significance,

- Understand Type I and Type II Errors,
- Understand the meaning of p-value,
- Understand Economic Significance and Statistical Significance,
- Understand and apply Bayes factor,
- Perform hypothesis testings (t-test) and calculate interval estimates,
- Apply Eviews for regression, hypothesis tests and interval estimation.

Section 1: Theory revision (30 minutes)

In this section, main points from Lecture notes - Week 04 will be revised.

Section 2: Working with Eviews

Download the file “capm5.wf1” from LMS.

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Eviews Instructions:

As with the tutorial last week, we are fitting the CAPM for the stocks in the data set with the
following regression model:

In this tutorial, we construct confidence interval for the β estimates, and conduct hypothesis
testing for α and β values, for the stocks of interest.

As an example, the estimation result for Disney stock is given below:

To calculate the confidence interval for the CAPM beta value of Disney stock, click View,
Coefficient Diagnostics, Confidence Intervals. Click OK, then you will see a table of
confidence intervals:

The 95% confidence interval for CAPM beta for Disney is calculated as (0.824, 1.198). You
can verify the interval based on the following calculation:

b2 ± tc se(b2) = 1.0112 ± 1.98 × 0.0946,

where tc = t(0.975, 178) = 1.98 is the 5% (two-tailed) critical value from Student-t distribution,
which can be obtained from the table for Student-t distribution.

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To conduct the test for H0: β = 1,

Click View, Coefficient Diagnostics, Wald test, and write the restriction c(2) = 1. Here c(2)
refers to the second coefficient in the regression model, which is the β coefficient. Click OK,
then you will see the test statistic and p-value reported.

Note that this is equivalent to calculating the t-statistic using this formula:

Note that the p-value for this test is also reported. With the p-value of 0.90, we cannot reject
H0: β = 1.

Similarly, to test for H0: α = 0, you should write “c(1) = 0”. However, the result is already
available from the regression output with t-statistic of 0.223 with the p-value = 0.8231 given
in the previous page. Again, we cannot reject H0: α = 0 in this case.

Please note the following two important points about the p-value for the t-test:

• the p-value reported in Eviews output is by default for the two-tailed test; and
• the p-value for the one-tailed test is half of the p-value for the two-tailed p-value.

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That is, for H0: α = 0 against H1: α ≠ 0, the p-value is

For H0: α = 0 against H1: α > 0, the p-value is

which is half of 0.8231.

This means that the p-value for the one-tailed test can be obtained from the p-value of the two-
tailed test routinely reported in Eviews. This rule applies to all t-tests in Eviews.

Section 3: Calculation and Interpretation (textbook questions)

During the 2-hour workshop, you are not required to answer all the questions in this section.
Instead, your facilitator will choose random questions to demonstrate and help you
understand/apply related econometric theories mentioned in Section 1.

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Section 4: Further self-practice

Again, choose a stock return from capm5.wf1 according to the last digit of your student ID as
below:

Stock Last digit of your Student ID

IBM 0, 1
GE 2, 3
XOM 4, 5
Microsoft 6, 7
Disney 8, 9

One of the assumptions of the regression model is that the error terms are conditionally
uncorrelated (SR4). In the context of time series data, this means that the error terms at different

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times are uncorrelated or show economically negligible correlation. This assumption is called
no serial correlation or no autocorrelation of the error term. That is,

Cov(et, et-1) = 0; Cov(et, et-2) = 0; and so on

Note that Cov(et, et-k) measures the covariance between the error terms that are k period apart,
and is called the autocovariance of error term of lag order k. That is, how much the current
shock is correlated with the shock k periods ago. If this covariance is different from zero
significantly, then we say that the error term is autocorrelated or serially correlated. And this
means that the assumption SR4 is violated.

The errors are not observable, but we can use residuals as estimates of these errors. To visualize
these correlations, you can present the time plots between et and et-k. For example, using the
residuals from the CAPM model estimation for Ford stock return, the following plots can be
generated:

In Eviews, after you run the CAPM regression, save the residual as e, as before (refer to Week
4 tutorial). From the pull-down menu, click Quick, Graph, and write e(-1) e in the pop-up
window as below:

Note that e(-1) indicates

the one lagged series of
e; and e(-2) indicates the
two-lagged series of e,
and so on.

Click OK and choose Scatter with Fit Regression Line. This will produce the scatter plot below
on the left. Repeat this process for e(-2) to produce the one on the right.

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It appears that et and et-1 show a weak and negative linear association, while et and et-2 show a
weak and positive linear association, from the residuals from CAPM estimation of Ford stock.

To generate the correlation matrix among these variables, click Quick from the pull-down
menu, Group Statistics, and Correlation, write the series list as below in the pop-up window.

Click OK, then you will see a matrix of correlations. These correlations are called the
autocorrelation of error term, with lag order 1 and 2.

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The autocorrelation of lag order 1 is -0.1295 and that of lag order 2 is 0.1049. This means that

• a current shock to Ford stock is negatively correlated with the shock of the past month
with correlation coefficient of -0.1295; and
• the shocks to Ford stock two months apart are correlated with the correlation coefficient
of 0.1049.

These correlation values are so close to 0 and may be negligible economically. On this basis,
we find evidence that the error terms are not strongly autocorrelated and that the assumption of
conditionally uncorrelated error term (SR4) is satisfied.

For your further practice,

• Generate the above scatter plots for your stock return

• Generate the correlation matrix of the residuals as above
• Provide a one-sentence comment in relation to the presence of autocorrelation in the
error term.