London South Bank University

Coursework Assignment 2022/23

Module Name: Empirical Finance (AFE-7-EMF)

Student ID: 4102045

Deadline Date: 9th December 2022 (4:00 PM)

Table of Contents

Sr. No. Particulars Page Number

1 Data 3
2 Question 1: Descriptive Statistics 3
3 Question 2: Beta 5
4 Question 3: ACF and PACF 7
5 Question 4: Unit Root Test 10
6 Question 5: Box-Jenkins Model 12
7 Question 6: Engle-Granger Test 13
8 Question 7: Correlation 14
9 Question 8: ARCH Model 15
10 Question 9: Error Correction Model 16
11 Question 10: Efficient Market Hypothesis 16
12 References 17
13 Appendix 1: Stata Do File 18

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Data:

For all the questions, the data has been downloaded from Bloomberg from 1st May 2019 to 1st
May 2021 for the FTSE100 Index, S&P500 Index, Lloyds LN Equity and Vodafone LN
Equity. The frequency of the data has been set to “Daily”. The entire dataset has been
downloaded to excel using the spreadsheet builder add-in of Bloomberg. The “Do File” for
all the commands run in Stata for this assignment has been attached as Appendix 1 to this
assignment.

Question 1:

Descriptive statistics is used to calculate brief informative coefficients which summarize a

data set. There are certain measures of central tendency which include mean, median and
mode and then there are certain measures like standard deviation, variance, skewness and
kurtosis which depict the variability of the data set. (Hayes, 2022)

The daily return of FTSE100 is calculated using the formula:

r t =ln
( )
Pt
Pt −1

The descriptive statistics have been calculated using the Stata command “summarize” and
“sktest”. The table given below summarizes the descriptive statistics for FTSE100:

Variable Mean Standard Skewness Kurtosis

Deviation
Daily FTSE Return -0.0001109 0.0140902 -1.2055 16.3726

Interpretation of results:

 Mean-
Mean of a data set indicates the middle of a distribution. The mean is also called
average expected value. The mean value for this distribution is -0.0001109. The
result shows that the returns on the FTSE100 are not volatile as the average return is
very close to zero.

 Standard Deviation-
The square root of the variance is used to calculate the standard deviation, a statistic
that expresses how widely distributed a dataset is in relation to its mean. The bigger
the deviation within the data collection, the further the data points deviate from the
mean; hence, the higher the standard deviation, the more dispersed the data.
(Hargrave, 2022) The standard deviation for this data set is 0.0140902. This indicates
that the data isn’t very volatile, and it is not very dispersed as compared to the mean.

 Skewness-

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 Asymmetry or distortion of a symmetric distribution is measured by skewness. It
calculates how far a particular random variable's distribution deviates from a
symmetric distribution like the normal distribution. Since it is symmetrical on both
sides, a normal distribution has no skewness. Therefore, a curve is considered to be
skewed if it is tilted to the right or left. (Corporate Finance Institute, 2022) The value
obtained for skewness is -1.2055 which means that the data set is slightly negatively
skewed.

 Kurtosis-
The "tailedness" of the probability distribution is gauged by kurtosis. The kurtosis of a
normal distribution is 3. The peak of a "bell" with an elevated kurtosis (>3) is thin and
has a high peak, whereas the peak of a "bell" with a lowered kurtosis is broader and
the tails are "thicker". (Kallner, 2018) The value of Kurtosis for this data set is
16.3726. This means that the distribution has an is an elevated one i.e., it has a high
peak, and the tails are narrow (leptokurtic).

 Histogram-
All the above results are also supported by the histogram of the distribution which
shows a bell-shaped curve with a high peak that is slightly skewed to the left.

Figure 1: Histogram

 Jacques-Bera Test-
This test is used to predict whether the data set is normally distributed. It is performed
when the number of observations is high. The formula to calculate the chi-squared
using JB test is given below:

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Null Hypothesis (H0): The data is normally distributed.

By using this formula, the value of chi is calculated to be 63.42. The critical value of chi at
5% significance level is 5.99 (table of chi-square). Since the value of chi is way higher than
the critical value, we reject the null hypothesis. This means that the FTSE100 returns are not
normally distributed. However, to apply most financial models and for the convenience of
users, it is generally assumed that Index returns are normally distributed.

Question 2:

The Beta of an investment or security is the measure of volatility of the returns generated by
it in comparison to the returns of the market. It is a measure of risk of the security. A higher
Beta implies more risk and a lower Beta means that the security is less risky. Beta is an
integral part of the Capital Assets Pricing Model (CAPM). (Corporate Finance Institute,
2022)

The following FTSE100 member companies are chosen for calculation of Beta:
1. Lloyds Banking Group PLC
2. Vodafone PLC

By running the regression command in Stata (“reg”) with the company’s daily return as the
dependent variable and the daily FTSE return as the independent variable, the following
values of Beta are obtained:

Particulars Beta as per Stata Beta as per

Bloomberg
Lloyds Banking Group PLC 1.300762 1.301
Vodafone PLC 0.9801336 0.980

Bloomberg can be used to find out the value of Beta for a selected stock by running the
“Beta” command. The beta values extracted from Bloomberg can be used to cross check the
values generated by Stata. As it can be seen in the table above, the values generated from
Stata and Bloomberg are exactly identical. This proves the efficiency of calculations done in
Stata.

The value of Beta for Lloyds Banking group PLC is 1.301, which means that the stock is
risky as compared to the stock market.

The value of Beta for Vodafone PLC is 0.980. This value is close to 1, which means that the
stock is as risky as the market.

With these results, we can conclude that Lloyds stock is riskier as compared to the Vodafone
stock.

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 Figure 2: Beta value of Lloyds Banking Group PLC

Figure 3: Beta value of Vodafone Group PLC

If we know the covariance and variance of a stock, there is another method to calculate Beta
by using the statistical formula:

Covariance
Beta=
Variance

Beta is an integral part of the Capital Assets Pricing Model (CAPM) which is used to
calculate the expected return of a security. The formula for CAPM is given below:

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Re = Rf + β (Rm – Rf)

Where, Re is the return of the equity, Rf is the risk free rate of return and Rm is the return of
the market. However, while calculating Beta using Stata, there is no mention of Risk-Free
Rate. The regression equation that Stata uses for this calculation is given below:

y= α + βx

When these 2 equations are compared, we can conclude that risk-free rate is the alpha. This
means that the regression command automatically calculates a constant which is the risk-free
rate as per CAPM.

Question 3:

The term "autocorrelation" describes the relationship between a time series and its own past
and present values. An autocorrelated time series is probabilistically predictable since future
values rely on present and past values, demonstrating how autocorrelation can be used to
make predictions. The ACF and PACF tests help in determining whether a time series is
autocorrelated. To choose the optimal model for forecasting, model orders such as p for AR
and q for MA must be provided via ACF and PACF plots.

 FTSE 100 Prices:

After running the ACF tests on the FTSE100 prices in Stata, the following
autocorrelation plots are obtained:

Figure 4: ACF for FTSE 100 stock prices

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 Figure 5: PACF for FTSE100 stock prices

Null Hypothesis (H0): The spikes in the lags are significant

An AR process is indicated by an ACF that is gradually geometrically decreasing and a

PACF that is meaningful for most of the lags. We can observe from the numbers that ACF is
falling gradually with lags. However, majority of the lags have a significant spike. Therefore,
we fail to reject the null hypothesis. (Rehal, 2022)

In the PACF plot, one substantial lag is followed by a decline in PACF values. Lags 1, 7, 8, 9
are higher than the critical value. So, for these values, we will reject the null hypothesis. For
all the other lags, we fail to reject the null hypothesis. Even though we are getting mixed
results, we still reject the null hypothesis because the spikes for some lags are significant.
This implies that the prices are correlated.

 FTSE 100 Daily Returns:

After running the PACF tests on the FTSE100 daily returns, the following partial
autocorrelation plots are obtained:

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 Figure 6: ACF of Daily FTSE100 Daily Returns

Figure 7: PACF for FTSE100 Daily Returns

In the ACF plot for returns, the spikes at lags 6, 7, 8, 13 and 14 are higher than the critical
value. So, we will reject the null hypothesis for these lags. For the remaining lags, we fail to

9
reject the null hypothesis. As we are getting mixed results, we shall reject the null hypothesis
as there are certain lags where the spikes are significant.

In the PACF plot for returns, the spikes at lags 5, 6, 7 and 8 are higher than the critical value.
So, we will reject the null hypothesis for these lags. For the remaining lags, we fail to reject
the null hypothesis. As we are getting mixed results, we shall reject the null hypothesis as
there are certain lags where the spikes are significant. This implies that the returns are
correlated.

Since, both the plots for the returns don’t have significant spikes in the first 5 lags, it can’t
explain the other spikes. Therefore, the p and q values for the ARMA model of FTSE100
returns is zero and therefore the appropriate model is AMRA (0,0).

Question 4:

Occasionally referred to as a "random walk with drift," a unit root is a stochastic trend in a
time series that exhibits an unforeseen systematic structure. (Glen, 2017) It checks whether
the time series variables of the data are stationary or non-stationary. The tests are used to
check stationarity are the Dickey-Fuller test and the Augmented Dickey-Fuller Test.

To perform the unit root test for FTSE100 prices and returns, the first step is to define the
date variable. Then, we run the Dickey-Fuller test with lags=0 and the Augmented Dickey-
Fuller test with lags=1. The results for FTSE100 prices are summarized below:

Test Statistic for Dickey-Fuller Critical Value

UKX Prices 1% 5% 10%
Z(t) -1.671 -3.430 -2.860 -2.570

Test Statistic for Augmented Dickey-Fuller Critical Value

UKX Prices 1% 5% 10%
Z(t) -1.684 -3.430 -2.860 -2.570

Null Hypothesis (H0) = The data is non-stationary and has a unit root with random walk.

We fail to reject the null hypothesis using the unit root test if the test statistic is higher than
the critical value at a particular level of significance. Similarly, if the test statistic is less than
the critical value at a particular level of significance, the null hypothesis is rejected.

In both the cases above, the value of the test statistic is greater than the critical values at all
the given significance levels. Thus, we fail to reject the null hypothesis. This means that the
FTSE100 prices have a unit root and is non-stationary.

The results for FTSE100 daily returns are summarized below:

Test Statistic Dickey-Fuller Critical Value

For UKX Returns 1% 5% 10%
Z(t) -23.021 -3.430 -2.860 -2.570

Test Statistic Augmented Dickey-Fuller Critical Value

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 For UKX Returns 1% 5% 10%
Z(t) -23.021 -3.430 -2.860 -2.570

Null Hypothesis (H0) = The data is non-stationary and has a unit root with random walk.

In both the cases, the value of the test statistics is lesser than the critical values at all
significance levels. Thus, we reject the null hypothesis. This means that the FTSE100 daily
returns do not have a unit root and are stationary.

The following plots are generated which depict the stationarity of the prices and returns of
FTSE100:

Figure 8: Graph Depicting prices and returns of FTSE100

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 Figure 9: Graph depicting the differenced prices and returns of FTSE100

Question 5:

The Box-Jenkins Model is a mathematical model that forecasts data ranges based on time
series inputs. For forecasting purposes, the Box-Jenkins Model can examine several forms of
time series data. Its technique determines outcomes by comparing data points. The
methodology allows the model to identify trends utilising autoregression, moving averages,
and seasonal differencing to provide forecasts. (Scott, 2022)

The first step of the Box Jenkins approach is to check whether the data has a unit root
(stationarity). As predicted in Question 4, the FTSE100 prices do have a unit root. The next
step is to examine the ACF and PACF graphs to determine which models can be a good
starting point and estimate the same. In this case, I have tried 3 different models namely
ARIMA (0,0,0), ARIMA (1,0,0) and ARIMA (1,0,1) and estimated the same.

AIC and BIC scores extracted from Stata:

Model df AIC BIC

arimaret~000 2 -2965.447 -2956.932
arimaret~100 3 -2963.503 -2950.73
arimaret~101 4 -2970.461 -2953.43

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To get the most accurate results for the ARMA model, the further diagnostics of the AIC and
BIC scores for each model can be done. The model with the least negative AIC and BIC
score will be the most preferable model. Hence, the ARMA (1,0,0) will be best suited.

Question 6:

Engle- Granger Test is a type of cointegration test. Based on the results of the static
regression, it creates residuals (errors). The Augmented Dickey-Fuller test or a comparable
test is used to check the residuals for the presence of unit roots. If the time series is
cointegrated, the residuals will be almost stationary.

To check whether FTSE100 and S&P500 are cointegrated, first we need to determine
whether both the variables have a unit root. For this, we will run the Augmented Dickey-
Fuller Test. According to the results obtained in Question 4, FTSE100 prices have a unit root
and are non-stationary.

In a similar way, we shall check if S&P500 prices are stationary or not by running the
Dickey-Fuller test and the Augmented Dickey-Fuller Test. The results for S&P prices are
summarized below:

Test Statistic Dickey-Fuller Critical Value

For SPX price 1% 5% 10%
Z(t) -0.468 -3.430 -2.860 -2.570

Test Statistic Augmented Dickey-Fuller Critical Value

For SPX price 1% 5% 10%
Z(t) 0.156 -3.430 -2.860 -2.570

Null Hypothesis (H0) = The data is non-stationary and has a unit root with random walk.

In both the cases, the value of the test statistic is lesser than the critical values at all the given
significance levels. Thus, we fail to reject the null hypothesis. This means that the S&P500
prices have a unit root and is non-stationary.

To check whether two variables are cointegrated, we can use either the Engle-Granger Test or
the regression on the residuals.

Engle-Granger Test:

Stata doesn’t directly contain an Engle-Granger Test, so we first install the “egranger”
command. Then we run the test on the FTSE100 and S&P500 and the following test statistics
are obtained:

Test Statistic Engle-Granger Critical Value

For SPX price 1% 5% 10%
Z(t) -1.675 -3.918 -3.348 -3.053

Null Hypothesis (H0) = No Cointegration exists

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The value of the test statistic is greater than the critical values at all the given significance
levels. Thus, we fail to reject the null hypothesis. This means that the FTSE100 and the
S&P500 are not cointegrated during the period considered.

Regression on residuals:
The first step is to perform a regression of both the variables and predict the residuals after
which a unit root test shall be run on the residuals. The results of the unit root test on the
residuals are as follows:

Test Statistic Dickey-Fuller Critical Value

For Residuals 1% 5% 10%
Z(t) -0.478 -3.430 -2.860 -2.570

Test Statistic Augmented Dickey-Fuller Critical Value

For Residuals 1% 5% 10%
Z(t) 0.141 -3.430 -2.860 -2.570

Null Hypothesis (H0) = No Cointegration exists

In both the cases, the value of the test statistic is greater than the critical values at all the
given significance levels. Thus, we fail to reject the null hypothesis. This means that the
FTSE100 and the S&P500 are not cointegrated during the period considered.

We can conclude that there is no cointegration between the FTSE100 and S&P500 by looking
at the results of both the Engle-Granger test and the regression on residuals.

Question 7:

The correlation coefficient is calculated to determine how strongly the variables are related.
Based on the characteristics of the variables, different methods can be used to calculate
correlation.

Linear method-
The Pearson coefficient, sometimes known as Pearson's r, is by far the most used method for
determining the strength and direction of a linear relationship between two variables. The
Pearson coefficient does not distinguish between dependent and independent variables, nor
can it evaluate nonlinear relationships between variables. (Fernando, 2021)

To determine the Pearson coefficient, we have used two tests in Stata. The first one is a linear
regression between FTSE100 and S&P500. The command for this test is “reg”. This gives us
a value of R-squared (square of the correlation coefficient). The other test is the correlation
test whose command is “correlate”. The result of this test directly gives us the value of the
correlation coefficient (r).

Non-Linear Method-
In this approach, correlation coefficient is calculated using the ranking method. One of the
methods to calculate this is the Spearman’s method. A statistical indicator of the strength of a
monotonic relationship between paired data is the Spearman's correlation coefficient. A

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monotonic function is one that, when the independent variable rises, either never increases or
never declines.

To determine the Spearman’s correlation in Stata, we have used the command “spearman” on
the FTSE100 and S&P500 daily returns. The result gives us the value of Spearman’s rho,
which is the correlation coefficient for the two variables.

Particulars R-squared Linear Correlation Non-Linear

(Regression Coefficient Correlation
Function) (Correlate Coefficient
Function) (Spearman’s method)
FTSE100 vs S&P500 0.4371 0.6611 0.4833

As it can be seen in the above table, the values of correlation calculated using both methods
are positive. This means that there is positive correlation between the two variables.
However, the intensity of correlation is different in both the methods. The Pearson’s r is
0.6611 which depicts moderate positive correlation. Whereas the Spearman’s rho is 0.4833
which depicts low positive correlation. (Malawi, 2012)

Another method to study correlation is the copula. A multivariate uniform distribution is

represented by the copula probability model, which evaluates the relationship or reliance
between numerous variables. Simply put, a copula aids in separating the joint or marginal
probabilities of two variables that are intertwined in a more complicated multivariate system.
When defining how those pairings join in the more intricate system, the copula is the special
index or collection of instructions. This technique is advantageous since it can assist in
finding erroneous correlations found in the data. (Kenton, 2021)

Question 8:

Autoregressive conditional heteroskedasticity (ARCH) is a statistical model used to examine

volatility in time series to forecast future volatility. ARCH modelling is used in finance to
quantify risk by giving a model of volatility that more closely mimics real markets.
According to ARCH modelling, periods of high volatility are followed by periods of low
volatility, and times of low volatility are followed by periods of high volatility. (Kenton,
2021)

To run the ARCH test for the FTSE100 daily returns, the first step is to run an ARIMA model
which will help us in predicting trends and understanding the dataset. I used the ARIMA
(1,1,1) model because three lags had three significant spikes as can be seen in Figure 6 above.
After this, an ARIMA regression is run for the FTSE100 returns which will lead to generation
of residuals. The ARCH test is applied on the variables. The following results are obtained:

Lags(p) Chi2 df Prob> chi2

1 9.356 1 0.0022

Null Hypothesis (H0) = There is no ARCH effect.

Since the p value is less than 0.05, the null hypothesis is rejected. This means that there is an
ARCH effect on the returns of FTSE100.

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Question 9:

Consider a relationship between two variables in terms of an Autoregressive Distributive Lag

(ADL) method. As per the Granger Representation Theorem, if two variables are
cointegrated, then the relationship between the two variables can be expressed as an Error
Correction Model (ECM).
As per the results of question 6, FTSE100 and S&P500 are not cointegrated. In order to apply
the Engle and Granger 2 step approach to form an Error Correction Model, the variables in
question need to have unit roots and be cointegrated. However, as proved in question 6,
FTSE100 and S&P500 do have unit roots but they are not cointegrated. Therefore, Error
Correction Model cannot be constructed for these two variables.

Question 10:

When dealing in stock markets, it is an accepted fact that stock prices trade at fair value.
According to the Efficient Market Hypothesis (EMH), asset prices already include and
represent all relevant information, making it impossible to outperform the market. This
suggests that today's efficient stock markets reflect all information that can influence an
investment in their stock prices. (Mishkin and Eakins, 2018)
Based on the efficiency of information, the EMH is broken down into three efficiency levels:

 Weak Form Efficiency- This means that the asset or stock’s current price reflects the
information contained in the historical price of the asset.
 Semi Strong Form Efficiency- Current asset values take into consideration
information from both historical and public sources, including news, accounting
reports, company management, analyst recommendations, patents, firm products, etc.
 Strong Form Efficiency- The information is expanded by the Strong Form Efficiency
to further encompass the confidential data kept by company insiders, such as fund
managers and corporate executives. Because it contains all the data already present in
the two previous forms, as well as additional private data, this version of the EMH is
the strongest.

In all the questions discussed above, the data that has been used is historic data. It doesn’t
include public information or insider information. The tests used in all the above questions
are single-variate tests or regression. This means that all these tests are run using a single
variable which is either price or return. There is no use of other fundamental variables like
macroeconomic variables, company performance, etc. while performing all the tests given
above. Since, the results are based only on the historic prices of the index, we can conclude
that the efficiency of the market for these results is weak form efficiency.

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 References
Corporate Finance Institute (2022a) Beta- The volatility of returns for an investment, relative to the market
. Available from: https://corporatefinanceinstitute.com/resources/valuation/what-is-beta-guide/ [Accessed
Dec 4, 2022].
Corporate Finance Institute (2022b) Skewness- A measure of the deviation of a random variable’s given
distribution from the normal distribution . Available
from: https://corporatefinanceinstitute.com/resources/data-science/skewness/ [Accessed Dec 5, 2022].
Fernando, J. (2021) The Correlation Coefficient: What It Is, What It Tells Investors. Available
from: https://www.investopedia.com/terms/c/correlationcoefficient.asp [Accessed Dec 3, 2022].
Glen, S. (2017) Unit Root: Simple Definition, Unit Root Tests. Available
from: https://www.statisticshowto.com/unit-root/ [Accessed Dec 4, 2022].
Hargrave, M. (2022) Standard Deviation Formula and Uses vs. Variance. Available
from: https://www.investopedia.com/terms/s/standarddeviation.asp [Accessed Dec 2, 2022].
Hayes, A. (2022) Descriptive Statistics: Definition, Overview, Types, Example. Available
from: https://www.investopedia.com/terms/d/descriptive_statistics.asp [Accessed Dec 3, 2022].
Kallner, A. (2018) Kurtosis. Available
from: https://www.sciencedirect.com/topics/neuroscience/kurtosis [Accessed Dec 3, 2022].
Kenton, W. (2021a) Autoregressive Conditional Heteroskedasticity (ARCH) Explained. Available
from: https://www.investopedia.com/terms/a/autoregressive-conditional-heteroskedasticity.asp [Accessed
Dec 2, 2022].
Kenton, W. (2021b) Copula. Available from: https://www.investopedia.com/terms/c/copula.asp [Accessed
Dec 3, 2022].
Malawi, J. (2012) A guide to appropriate use of Correlation coefficient in medical research. Available
from: https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3576830/ [Accessed Dec 2, 2022].
Mishkin, F. S. and Eakins, S. G. (2018) Financial markets and institutions. Ninth , global ed.Harlow,
England; 4: Pearson.
Ouattara, B. S. (2017) Re-examining stock market integration among brics countries, Eurasian Journal of
Economics and Finance, 5 (3), pp. 109-132. DOI: 10.15604/ejef.2017.05.03.009.
Rehal, V. (2022) Interpreting ACF and PACF plots. Available
from: https://spureconomics.com/interpreting-acf-and-pacf-plots/ [Accessed Dec 3, 2022].
Scott, G. (2022) Box-Jenkins Model: Definition, Uses, Timeframes, and Forecasting. Available
from: https://www.investopedia.com/terms/b/box-jenkins-model.asp [Accessed Dec 2, 2022].
Teggi, P. (2020) 5 Steps : To get an understanding on Correlation, Auto-Correlation and Partial Auto-
Correlation. Available from: https://medium.com/analytics-vidhya/5-steps-to-get-an-understanding-on-
correlation-auto-correlation-and-partial-auto-correlation-e71f6b4bba81 [Accessed Dec 4, 2022].

Appendix 1: Do File for Stata

//Question 1

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import excel "/Users/vrutika25/Library/CloudStorage/OneDrive-
LondonSouthBankUniversity/EF assignment data set- Latest.xlsx", sheet("Dataset") firstrow
tsset Dates
summarize RUKX
sktest RUKX
histogram RUKX, bin(100)

//Question 2
reg RLLOY RUKX
reg RVOD RUKX

//Question 3
tsset Time
corrgram UKX, lags(20)
ac UKX
pac UKX
corrgram RUKX, lags(20)
ac RUKX
pac RUKX
reg RUKX L.RUKX
reg RUKX L1.RUKX L2.RUKX

//Question 4
line UKX Dates
line RUKX Dates
twoway (line UKX Dates) (line RUKX Dates, yaxis(2))
line DUKXP Dates
line DUKXR Dates
twoway (line DUKXP Dates) (line DUKXR Dates, yaxis(2))
dfuller UKX, lags(0)
dfuller UKX, lags(1)
dfuller RUKX, lags(0)
dfuller RUKX, lags(1)

//Question 5
arima RUKX
est sto arimareturn000
arima RUKX, arima(1,0,0)
est sto arimareturn100
arima RUKX, arima(1,0,1)
est sto arimareturn101
est stats _all

//Question 6
dfuller SPX, lags(0)
dfuller SPX, lags(1)
ssc install egranger
egranger UKX SPX, reg
reg SPX UKX
predict r, residuals

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dfuller r, lags(0)
dfuller r, lags(1)

//Question 7
reg RUKX RSPX
correlate RUKX RSPX
spearman RUKX RSPX

//Question 8
arima RUKX, arima(1,1,1)
arima RUKX, ar(1) ma(1)
reg RUKX, c
predict resid, r
archlm

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