Cfa L1 Session03

Study Session 2 Quantitative Methods (II)
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Study Session 3
Quantitative Methods (II)

A. Sampling and Estimation

a. define simple random sampling.

In investment analysis, it is oIten impossible to study every member oI the population.
Even iI we could examine the entire population, it may not be economically eIIicient
to do so. Sampling is the process oI obtaining a sample. A simple random sample is
a sample obtained in such a way that each element oI the population has an equal
probability oI being selected. The selection oI any one element has no impact on the
chance oI selecting another element.

A sample is random iI the method Ior obtaining the sample meets the criterion oI
randomness (each element having an equal chance at each draw). The actual
composition oI the sample itselI does not determine whether or not it`s a random
sample.

A biased sample is one in which the method used to create the sample results in
samples that are systematically diIIerent Irom the population. For instance, consider a
research project on attitudes toward sex. Collecting the data by publishing a
questionnaire in a magazine and asking people to Iill it out and send it in would
produce a biased sample. People interested enough to spend their time and energy
Iilling out and sending in the questionnaire are likely to have diIIerent attitudes
toward sex than those not taking the time to Iill out the questionnaire.

It is important to realize that it is the method used to create the sample not the actual
make up oI the sample itselI that deIines the bias. A random sample that is very
diIIerent Irom the population is not biased: it is by deIinition not systematically
diIIerent Irom the population. It is randomly diIIerent.

b. define and interpret sampling error.
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The sample taken Irom a population is used to inIer conclusions about the population.
However, it's unlikely that the sample statistic would be identical to the population
parameter. Sampling error (also called error of estimation) is the diIIerence
between the observed value oI a statistic and the quantity it is intended to estimate.
For example, sampling error oI the mean sample mean - population mean.

The statistic can be an estimate oI some unknown population parameter. The sampling
error varies Irom sample to sample. A good estimator is one whose sample error
distribution is highly concentrated about the population parameter value.

c. define a sampling distribution.

A sample statistic itselI is a random variable and thereIore has a probability
distribution. The sampling distribution oI a statistic is the distribution oI all the
distinct possible values that the statistic can assume when computed Irom samples oI
the same size randomly drawn Irom the same population. The most commonly used
sample statistics include mean, variance, and standard deviation.

II you compute the mean oI a sample oI 10 numbers, the value you obtain will not
equal the population mean exactly; by chance it will be a little bit higher or a little bit
lower. II you sampled sets oI 10 numbers over and over again (computing the mean
Ior each set), you would Iind that some sample means come much closer to the
population mean than others. Some would be higher than the population mean and
some would be lower. Imagine sampling 10 numbers and computing the mean over
and over again, say about 1,000 times, and then constructing a relative Irequency
distribution oI those 1,000 means. This distribution oI means is a very good
approximation to the sampling distribution oI the mean. The sampling distribution oI
the mean is a theoretical distribution that is approached as the number oI samples in
the relative Irequency distribution increases. With 1,000 samples, the relative
Irequency distribution is quite close; with 10,000 it is even closer. As the number oI
samples approaches inIinity, the relative Irequency distribution approaches the
sampling distribution.

The sampling distribution oI the mean Ior a sample size oI 10 is just an example; there
is a diIIerent sampling distribution Ior other sample sizes. Also, keep in mind that the
relative Irequency distribution approaches a sampling distribution as the number oI
samples increases, not as the sample size increases since there is a diIIerent sampling
distribution Ior each sample size.

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A sampling distribution can also be deIined as the relative Irequency distribution that
would be obtained iI all possible samples oI a particular sample size were taken. For
example, the sampling distribution oI the mean Ior a sample size oI 10 would be
constructed by computing the mean Ior each oI the possible ways in which 10 scores
could be sampled Irom the population and creating a relative Irequency distribution oI
these means. Although these two deIinitions may seem diIIerent, they are actually the
same: Both procedures produce exactly the same sampling distribution.

Statistics other than the mean have sampling distributions too. The sampling
distribution oI the median is the distribution that would result iI the median instead oI
the mean were computed in each sample.

Sampling distributions are very important since almost all inIerential statistics are
based on sampling distributions.

d. distinguish between simple random and stratified random sampling.

In stratified random sampling, the population is subdivided into subpopulations
(strata) based on one or more classiIication criteria. Simple random samples are then
drawn Irom each stratum (the sizes oI the samples are proportional to the relative size
oI each stratum in the population). These samples are then pooled.

StratiIied random sampling guarantees that population subdivisions oI interest are
represented in the sample. The estimates oI parameters produced Irom startiIied
sampling have greater precision -- that is, smaller variance or dispersion -- than
estimates obtained Irom simple random sampling.

For example, investors may want to Iully duplicate a bond index by owning all the
bonds in the index in proportion to their market value weights. This is known as pure
bond indexing. However, it's diIIicult and costly to implement because a bond index
typically consists oI thousands oI issues. II simple sampling is used, the sample
selected may not accurately reIlect the risk Iactors oI the index. StratiIied random
sampling can be used to replicate the bond index.
Divide the population oI index bonds into groups with similar risk Iactors (e.g.
issuer, duration/maturity, coupon rate, credit rating, call exposure, etc). Each
group is called a stratum or cell.
Select a sample Irom each cell proportional to the relative market weighting oI
the cell in the index.

A stratiIied sample will ensure that at least 1 issue in each cell is included in the
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sample.

e. distinguish between time-series and cross-sectional data.

OIten Iinancial analysts are interested in particular types oI data such as time-series
data or cross-sectional data. A random sample taken Irom the data set must be
representative oI the underlying population.

Time-series data is a set oI observations collected at usually discrete and
equally spaced time intervals. For example, the daily closing price oI a certain
stock recorded over the last 6 weeks is an example oI time-series data. Note
that a too long or too short time period may lead to time-period bias. ReIer to
los m Ior details.

Cross-sectional data are observations that coming Irom diIIerent individuals or
groups at a single point in time. For example, iI one considered the closing
prices oI a group oI 20 diIIerent tech stocks on December 15, 1986 this would
be an example oI cross-sectional data. Note that the underlying population
should consist oI members with similar characteristics. For example, suppose
you are interest in how much companies spend on research and development
expenses. Firms in some industries such as retail spend little on R&D, while
Iirms in industries such as technology spend heavily on R&D. ThereIore, it's
inappropriate to summarize R&D data across all companies. Rather, analysts
should summarize R&D data by industry, and then analyze the data in each
industry group.

f. state the central limit theorem and describe its importance.

The central limit theorem states that given a distribution with a mean m and variance
s
2
, the sampling distribution oI the mean approaches a normal distribution with a
mean (m) and a variance s
2
/N as N, the sample size, increases.

The amazing and counter-intuitive thing about the central limit theorem is that no
matter what the shape oI the original distribution, the sampling distribution oI the
mean approaches a normal distribution. Furthermore, Ior most distributions, a normal
distribution is approached very quickly as N increases (in general when N is bigger
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than 30).

Keep in mind that N is the sample size Ior each mean and not the number oI samples.
Remember in a sampling distribution the number oI samples is assumed to be inIinite.
The sample size is the number oI scores in each sample; it is the number oI scores that
goes into the computation oI each mean.

Two things should be noted about the eIIect oI increasing N:
The distributions become more and more normal.
The spread oI the distributions decreases.

Based on the central limit theorem, when the sample size is large, we can:
Use the sample mean to inIer the population mean.
Construct conIidence intervals Ior the population mean based on the normal
distribution.

Note that the central limit theorem does not prescribe that the underlying population
must be normally distributed. ThereIore, the central limit theorem can be applied on a
population with any probability distribution.

g. calculate and interpret the standard error of the sample mean.

The standard error oI a statistic is the standard deviation oI the sampling distribution
oI that statistic.

Standard errors are important because they reIlect how much sampling Iluctuation a
statistic will show. The inIerential statistics involved in the construction oI conIidence
intervals and signiIicance testing are based on standard errors. The standard error of
a statistic depends on the sample size. In general, the larger the sample size the
smaller the standard error. The standard error oI a statistic is usually designated by the
Greek letter sigma () with a subscript indicating the statistic. For instance, the
standard error oI the mean is indicated by the symbol:
m
.

The standard error of the mean is designated as:
m
. It is the standard deviation oI
the sampling distribution oI the mean. The Iormula Ior the standard error oI the mean
is:
m
/N
1/2
, where is the standard deviation oI the original distribution and
N is the sample size (the number oI scores each mean is based upon). This Iormula
does not assume a normal distribution. However, many oI the uses oI the Iormula do
assume a normal distribution. The Iormula shows that the larger the sample size, the
smaller the standard error oI the mean. More speciIically, the size oI the standard error
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oI the mean is inversely proportional to the square root oI the sample size.

When s (sample standard deviation) is used as an estimate oI (when we don't
know it), the estimated standard error oI the mean is s/N
1/2
. In most practical
applications we need to use this Iormula because the population standard deviation is
almost never available.

h. distinguish between a point estimate and a confidence interval estimate of a
population parameter.

The single estimate oI an unknown population parameter calculated as a sample mean
is called point estimate oI the mean. The Iormula used to compute the point estimate
is called an estimator. The speciIic value that we calculate Irom sample observations
using an estimator is called an estimate. For example, the sample mean is a point
estimate oI the population mean. Suppose we take two samples Irom a population,
and the sample means are 16 and 21 respectively. 16 and 21 are two estimates oI the
population mean. Note that an estimator will yield diIIerent estimates as repeated
samples are taken Irom the sample population.

A confidence interval is an interval Ior which one can assert with a given probability
1 - a, called the degree of confidence, that it will contain the parameter it is intended
to estimate. This interval is oIten reIerred to as the (1 - a) conIidence interval Ior the
parameter, where a is reIerred to as the level of significance. The end points oI a
conIidence interval are called the lower and upper confidence limits.

For example, suppose that a 95 conIidence interval Ior the population mean is 20 to
40. This means that there is a 95 probability that the population mean lies in the
range oI 20 to 40. '95 is the degree oI conIidence. '5 is the level oI signiIicance.
20 and 40 are the lower and higher conIidence limits, respectively.

i. identify and describe the desirable properties of an estimator.

There are three desirable properties oI estimators:

unbiasedness
An estimator's expected value (the mean oI its sampling distribution) equals the
parameter it is intended to estimate. For example, the sample mean is an unbiased
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estimator oI the population mean, because the expected value oI the sample mean
is equal to the population mean.

efficiency
An estimator is eIIicient iI no other unbiased estimator oI the sample parameter
has a sampling distribution with smaller variance. That is, in repeated samples,
we expect the estimates Irom an eIIicient estimator to be more tightly grouped
around the mean than estimates Irom other unbiased estimators. For example, the
sample mean is an eIIicient estimator oI the population mean, and the sample
variance is an eIIicient estimator oI the population variance.

consistency
A consistent estimator is one Ior which the probability oI accurate estimates
(estimates close to the value oI the population parameter) increases as sample size
increases. In other words, a consistent estimator's sampling distribution becomes
concentrated on the value oI the parameter it is intended to estimate as the sample
size approaches inIinity. For example, as the sample size increases to inIinity, the
standard error oI the sample mean declines to 0, and the sampling distribution
concentrates around the population mean. ThereIore, the sample mean is a
consistent estimator oI the population mean.

j. calculate and interpret a confidence interval for a population mean, given a
normal distribution with 1) a known population variance or 2) an unknown
population variance.

ConIidence intervals are typically constructed by using the Iollowing structure:
ConIidence interval Point Estimate - Reliability Factor x Standard Error

Point estimate is the value oI a sample statistic oI the population parameter.
Reliability Iactor is a number based on the sampling distribution oI the point
estimate and the degree oI conIidence (1 a).
Standard error reIers to the standard error oI the sample statistic that is used to
produce the point estimate.

Whatever the distribution oI the population, the sample mean is always the point
estimate used to construct the conIidence intervals Ior the population mean. The
reliability Iactor and the standard error, however, may vary depending on three
Iactors:
Distribution oI population: normal or non-normal.
Population variance: known or unknown.
Sample size: large or small.
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z-Statistic: a standard normal random variable

II a population is normally distributed with a known variance, z-statistic is used as the
reliability Iactor to construct conIidence intervals Ior the population mean.

In practice, the population standard deviation is rarely known. However, learning how
to compute a conIidence interval when the standard deviation is known is an excellent
introduction to how to compute a conIidence interval when the standard deviation has
to be estimated.

Three values are used to construct a conIidence interval Ior u: the sample mean (M),
the value oI z (which depends on the level oI conIidence), and the standard error oI
the mean ()
M
. The conIidence interval has M Ior its center and extends a distance
equal to the product oI z and in both directions. ThereIore, the Iormula Ior a
conIidence interval is:
M - z s
M
u M z s
M

For a (1 a) conIidence interval Ior the population mean, the z-statistic to be used
is z
a/2
. z
a/2
denotes the points oI the standard normal distribution such that a/2 oI the
probability Ialls in the right-hand tail.

Commonly used reliability Iactors are as Iollows:
90 conIidence intervals: z
0.05
1.645. a is 10, with 5 in each tail.
0.025
1.96. a is 5, with 2.5 in each tail
0.005
2.575. a is 1, with 0.5 in each tail

Assume that the standard deviation oI SAT verbal scores in a school system is known
to be 100. A researcher wishes to estimate the mean SAT score and compute a 95
conIidence interval Irom a random sample oI 10 scores.

The 10 scores are: 320, 380, 400, 420, 500, 520, 600, 660, 720, and 780. ThereIore, M
530, N 10, and
M
100 / 10
1/2
31.62. The value oI z Ior the 95 conIidence
interval is the number oI standard deviations one must go Irom the mean (in both
directions) to contain .95 oI the scores.

It turns out that one must go 1.96 standard deviations Irom the mean in both directions
to contain .95 oI the scores. The value oI 1.96 was Iound using a z table. Since each
tail is to contain .025 oI the scores, you Iind the value oI z Ior which 1 - 0.025 0.975
oI the scores are below. This value is 1.96.

All the components oI the conIidence interval are now known: M 530,
M
31.62,
z 1.96.
Lower limit 530 - (1.96)(31.62) 468.02
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Upper limit 530 (1.96)(31.62) 591.98

ThereIore, 468.02 u 591.98. This means that the experimenter can be 95
certain that the mean SAT in the school system is between 468 and 592. Notice that
this is a rather large range oI scores. Naturally, iI a larger sample size had been used,
the range oI scores would have been smaller.

The computation oI the 99 conIidence interval is exactly the same except that 2.58
rather than 1.96 is used Ior z. The 99 conIidence interval is: 448.54 u 611.46.
As it must be, the 99 conIidence interval is even wider than the 95 conIidence
interval.

Summary oI Computations
Compute M X/N.
Compute
M
/N
1/2

Find z (1.96 Ior 95 interval; 2.58 Ior 99 interval)
Lower limit M - z x
M

Upper limit M z x
M

Lower limit u Upper limit

Assumptions:
Normal distribution
is known
Scores are sampled randomly and are independent

It is very rare Ior a researcher wishing to estimate the mean oI a population to already
know its standard deviation. ThereIore, the construction oI a conIidence interval
almost always involves the estimation oI both u and .

Student`s t-Distribution

When is known, the Iormula: M z
M
u M z
M
is used Ior a
conIidence interval. When is not known,
M
/N
1/2
(N is the sample size) is
used as an estimate oI and u. Whenever the standard deviation is estimated, the t
rather than the normal (z) distribution should be used. The values oI t are larger than
the values oI z so conIidence intervals when is estimated are wider than
conIidence intervals when is known. The Iormula Ior a conIidence interval Ior u
when is estimated is:
M - t s
M
u M t s
M

where M is the sample mean, s
M
is an estimate oI
M
, and t depends on the degrees
oI Ireedom and the level oI conIidence.

Like a standard normal distribution (i.e. a z-distribution), the t-distribution is
symmetrical around its mean. Unlike a standard normal distribution, the t-distribution
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has the Iollowing unique characteristics.
There is not one t-distribution, but a Iamily oI t-distributions. All
t-distributions have the same mean oI 0. Standard deviations oI these
t-distributions diIIer according to the sample size, n.
The t-distribution is less peaked than a standard normal distribution, and has
Iatter tails (that is, more probability in the tails).

The value oI t can be determined Irom a t table. The degrees oI Ireedom Ior t is equal
to the degrees oI Ireedom Ior the estimate oI
M
which is equal to N-1.

A portion oI t-table is presented as below:

Suppose the sample size (n) is 30, and the level oI signiIicance (a) is 5. df n - 1
29. t
a/2
t
0.025
2.045 (Find the 29 df row, and then move to the 0.05 column).

Assume a researcher were interested in estimating the mean reading speed (number oI
words per minute) oI high-school graduates and computing the 95 conIidence
interval. A sample oI 6 graduates was taken and the reading speeds were: 200, 240,
300, 410, 450, and 600. For these data,
M 366.6667
s
M
60.9736
dI 6-1 5
t 2.571

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ThereIore, the lower limit is: M - (t) (s
M
) 209.904 and the upper limit is: M (t) (s
M
)
523.430. ThereIore, the 95 conIidence interval is: 209.904 u 523.430
Thus, the researcher can be 95 sure that the mean reading speed oI high-school
graduates is between 209.904 and 523.430.

Compute M X/N.
Compute s
Compute
M
s/N
1/2

Compute dI N-1
Find t Ior these dI using a t table
Lower limit M - t s
M

Upper limit M t s
M

Lower limit u Upper limit

Assumptions:
Normal distribution
Scores are sampled randomly and are independent

k. discuss the issues surrounding selection of the appropriate sample size.

When a large sample size (generally bigger than 30 samples) is used, we can always
use z table to construct the conIidence interval. It does not matter iI the population
distribution is normal, or iI the population variance is known or not. This is because
the central limit theorem assures that when the sample is large, the distribution oI the
sample mean is approximately normal. However, the t-statistic is more conservative
because the t-statistic tends to be greater than the z-statistic, and thereIore
usingt-statistic will result in a wider conIidence interval.

However, iI we only have a small sample size, we have to use t table to construct the
conIidence interval when the population distribution is normal but the population
variance is not known.

II the population distribution is not normal, there is no way to construct a conIidence
interval Irom a small sample (even iI we know the population variance).

ThereIore, all else equal, we should try to select a sample larger than 30. The larger
the sample size, the more precise the conIidence interval.

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l. define and discuss data-snooping/data-mining bias.

Data-snooping bias is the bias in the inIerence you draw as a result oI prying into the
empirical results oI others to guide your own analysis.

Finding seemingly signiIicant but in Iact spurious patterns in the data is a serious
problem in Iinancial analysis. Although it aIIlicts all non-experimental sciences,
data-snooping is particularly problematic Ior Iinancial analysis because oI the large
number oI empirical studies perIormed on the same datasets. Given enough time,
enough attempts, and enough imagination, almost any pattern can be teased out oI any
dataset. In some cases, these spurious patterns are statistically small, almost
unnoticeable in isolation. But because small eIIects in Iinancial calculations can oIten
lead to very large diIIerences in investment perIormance, data-snooping biases can be
surprisingly substantial.

For example, aIter examining the empirical evidence Irom 1986 to 2002, proIessor
Minard concludes that a growth investment strategy produces superior investment
perIormance. AIter reading about ProIessor Minard's study, Monica decides to
conduct a research oI growth vs value investing based on the same or related
historical data used by ProIessor Minard. Monica's research is subject to
data-snooping bias because, among other things, the data used by ProIessor Minard
may be spurious.

The best way to avoid data-snooping bias is to examine new data. However,
data-snooping bias is diIIicult to avoid because investment analysis is typically based
on historical or hypothesized data.

Data-snooping bias can easily lead to data-mining bias.

Data-mining is the practice oI Iinding Iorecasting models by extensive searching
through databases Ior patterns or trading rules (that is, repeatedly "drilling" in the
same data until you Iind something). It has a very speciIic deIinition: Continually
mixing and matching the elements oI a database until one "discovers" two more or
more data series that are highly correlated. Data mining also reIers more generically
to any oI a number oI practices in which data can be tortured into conIessing
anything.

Two signs may indicate the existence oI data mining in research Iindings about
proIitable trading strategies:
Many oI the variables actually used in the research are not reported. These
terms may indicate that the researchers were searching through many
unreported variables.
There is no plausible economic theory available to explain why those
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strategies work.

To avoid data-mining, analysts should use out-oI-sample data to test a potentially
proIitable trading rule. That is, analysts should test the trading rule on a data set other
than the one used to establish the rule.

m. define and discuss sample selection bias, survivorship bias, look-ahead bias, and
time-period bias.

sample selection bias
When data availability leads to certain assets being excluded Irom the analysis, we
call the resulting problem sample selection bias. The discrete choice has become a
popular tool Ior assessing the value oI non-market goods. Surveys used in these
studies Irequently suIIer Irom large non-response which can lead to signiIicant bias in
parameter estimates and in the estimate oI mean.

survivorship bias
This is the most common type oI sample selection bias. It occurs when studies are
conducted on databases that have eliminated all companies that have ceased to exist
(oIten due to bankruptcy). The Iindings Irom such studies most likely will be
upwardly biased, since the surviving companies will look better than those that no
longer exist. For example, many mutual Iund databases provide historical data about
only those Iunds that are currently in existence. As a result, Iunds that have ceased to
exist due to closure or merger do not appear in these databases. Generally, Iunds that
have ceased to exist have lower returns relative to the surviving Iunds. ThereIore, the
analysis oI a mutual Iund database with survivorship bias will overestimate the
average mutual Iund return because the database only includes the better-perIorming
Iunds. Another example is the return data on stocks listed on an exchange as it is
subject to survivorship bias: it's diIIicult to collect inIormation on delisted companies
and these companies oIten have poor perIormance.

look-ahead bias
This exists when studies assume that Iundamental inIormation is available when it is
not. For example, researchers oIten assume you had annual earnings data in January;
in reality the data might not be available until March. This usually biases results
upwards.

time period bias
A test design is subject to time-period bias iI it is based on a time period that may
make the results time-period speciIic. Even the worst perIormers have months or even
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years in which they look wonderIul. AIter all, stopped clocks are right once a day. To
eliminate strategies that have just been lucky, research must encompass many years.
However, iI the time period is too long, the Iundamental economic structure may have
changed during the time Irame, resulting in two data sets that reIlect diIIerent
relationships.

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B. Hypothesis Testing

a. define a hypothesis and describe the steps of hypothesis testing.

A hypothesis is a statement about a population created Ior the purpose oI statistical
testing.

Examples oI hypotheses made about a population parameter are:
The mean monthly income Ior a Iinancial analyst is $5,000.
Twenty-Iive percent oI R&D costs are ultimately written oII.
Nineteen percent oI net income statements are later Iound to be materially
incorrect.

Hypothesis testing is a procedure based on probability theory and sample evidence
used to evaluate whether the hypothesis is a reasonable statement.

Testing a Hypothesis

1. State the Null Hypothesis and the Alternate Hypothesis
The Iirst step is to state the null hypothesis (designated: H
0
), which is the
statement that is to be tested. The null hypothesis is a statement about the value oI
a population. We will either reject, or Iail to reject, the null hypothesis.
The alternate hypothesis is the statement that is accepted iI the sample data
provides suIIicient evidence that the null hypothesis is Ialse. It is designated as H
1
,
and is accepted iI the sample data provides suIIicient statistical evidence that H0
is Ialse.

2. Determine the Appropriate Test Statistic and its Probability Distribution
A test statistic is simply a number, calculated Irom a sample, whose value,
relative to its probability distribution, provides a degree oI statistical evidence
against the null hypothesis. In many cases, the test statistic will not provide
evidence suIIicient to justiIy rejecting the null hypothesis. However, sometimes
the evidence will be strong enough so that the null hypothesis is rejected and the
alternative hypothesis is accepted instead.
Typically, the test statistic will be oI the general Iorm:
test statistic (sample statistic - parameter value under H
0
) / standard error oI
sample statistic

3. Select the Level oI SigniIicance
AIter setting up H
0
and H
1
, the next step is to state the level of significance,
which is the probability oI rejecting the null hypothesis when it is actually true.
We use alpha to represent this probability. The idea behind setting the level oI
signiIicance is to choose the probability that your decision will be subject to a
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Type I error. There is no one level oI signiIicance that is applied to all studies
involving sampling. A decision by the researcher must be made to use the 0.01
level, 0.05 level, 0.10 level, or any other level between 0 and 1. A lower level oI
signiIicance means that there is a lower probability that you will make a Type I
error.

4. Formulate the Decision Rule
A decision rule is a statement oI the conditions under which the null hypothesis
will be rejected and under which it will not be rejected.
The critical value (or rejection point) is the dividing point between the region
where the null hypothesis is rejected and the region where it is not rejected. The
region oI rejection deIines the location oI all those values that are so large (in
absolute value) that the probability oI their occurrence is low iI the null
hypothesis is true.

5. Collect the Data, PerIorm Calculations
Once the data is collected, the test statistic should be calculated.

6. Making a Decision
II the test statistic is greater than the higher critical value (or, in a two-tailed test,
less than the lower critical value), then the null hypothesis is rejected in Iavor oI
the alternative hypothesis.

7. Making an Investment Decision
Making an investment decision (or economic decision) entails not just the use oI
statistical decision algorithms, but economic considerations as well.

b. define and interpret the null hypothesis and alternative hypothesis.

The null hypothesis (designated: H
0
) is the statement that is to be tested. The null
hypothesis is a statement about the value oI a population. We will either reject, or Iail
to reject, the null hypothesis.

For example, the null hypothesis could be "The mean monthly return Ior
stocks listed on the Vancouver Stock Exchange is not signiIicantly diIIerent
Irom 1." Note that this is the same as saying the mean (u) monthly return on
stocks listed on the Vancouver Stock Exchange is equal to 1. This null
hypothesis, H
0
, would be written as: H
0
: u 1.

As another example, iI a null hypothesis is stated as "There is no diIIerence in
CFACENTER.COM 17
the revenue growth rate Ior satellite TV dishes beIore and aIter the negative
TV advertising campaign aired by the cable industry," then the null hypothesis
could be written to show that two rates are equal: H
0
: r1 r2.

It is important to point out that accepting the null hypothesis does not prove that it is
true. It simply means that there is not suIIicient evidence to reject it.

The alternate hypothesis is the statement that is accepted iI the sample data provides
suIIicient evidence that the null hypothesis is Ialse. It is designated as H
1
, and is
accepted iI the sample data provides suIIicient statistical evidence that H
0
is Ialse.

The Iollowing example clariIies the diIIerence between the two hypotheses. Suppose
the mean time to market Ior a new pharmaceutical drug is thought to be 3.9 years. The
null hypothesis represents the current or reported condition and would thereIore be H
0
:
u 3.9. The alternate hypothesis is that the statement is not true, that is, H
1
: u ~ 3.9
(where ~ means "does not equal."). The null and alternative hypotheses account Ior
all possible values oI the population parameter.

There are three basic ways oI Iormulating the null hypothesis.
H
0
: u u
0
, versus H
1
: u ~ u
0
. This hypothesis is two-tailed, which means that
you are testing evidence that the actual parameter may be statistically greater
or less than the hypothesized value.

H
0
: u u
0
, versus H
1
: u ~ u
0
. This hypothesis is one-tailed; it tests whether
there is evidence that the actual parameter is signiIicantly greater than the
hypothesized value. II there is, you reject the null hypothesis. II there is not,
you accept the null hypothesis.

H
0
: u ~ u0, versus H
1
: u u
0
there is evidence that the actual parameter is signiIicantly less than the

It is important to remember that no matter how the problem is stated, the null
hypothesis will always contain the equal sign-either the plain equal sign , the "less
than or equal to" sign or the "greater than or equal to" sign ~.

c. distinguish between one-tailed and two-tailed hypothesis tests.

There are three basic ways oI Iormulating the null hypothesis.
CFACENTER.COM 18
H
0
: u u
0
, versus H
1
: u ~ u
0
. This hypothesis is two-tailed, which means that
you are testing evidence that the actual parameter may be statistically greater
or less than the hypothesized value.

H
0
: u u
0
, versus H
1
: u ~ u
0
there is evidence that the actual parameter is signiIicantly greater than the

H
0
: u ~ u
0
, versus H
1
: u u
0
there is evidence that the actual parameter is signiIicantly less than the

d. define and interpret a test statistic and a significance level and explain how
significance levels are used in hypothesis testing.

A test statistic is simply a number, calculated Irom a sample, whose value, relative to
its probability distribution, provides a degree oI statistical evidence against the null
hypothesis. In many cases, the test statistic will not provide evidence suIIicient to
justiIy rejecting the null hypothesis. However, sometimes the evidence will be strong
enough so that the null hypothesis is rejected and the alternative hypothesis is
accepted instead.

The value oI the test statistic is the Iocal point oI assessing the validity oI a hypothesis.
Typically, the test statistic will be oI the general Iorm:
Test statistic (sample statistic - Parameter value under H
0
) / standard error of
sample statistic.

For example, a test statistic Ior the mean oI a distribution (such as the mean monthly
return Ior a stock index) oIten Iollows a standard normal distribution. In such a case,
the test statistic requires use oI the z-test, P(Z test statistic z). This is shown as:
Test statistic (X-bar - u
0
) / (s / n
1/2
) z
Where:
X-bar sample mean
u
0
hypothesized value
s sample standard deviation
n sample size

Note that this assumes the population variance (and, thereIore, the population
CFACENTER.COM 19
standard deviation as well) is unknown, and can only be estimated Irom the sample
data.

There are other probability distributions as well, such as the t, the chi-square, and the
F. Depending on the characteristics oI the population and the sample, a test statistic
may Iollow one oI these distributions, which will be discussed later.

AIter setting up H
0
and H
1
, the next step is to state the level oI signiIicance, which is
the probability oI rejecting the null hypothesis when it is actually true. We use alpha
to represent this probability. The idea behind setting the level oI signiIicance is to
choose the probability that your decision will be subject to a Type I error. There is no
one level oI signiIicance that is applied to all studies involving sampling. A decision
by the researcher must be made to use the 0.01 level, 0.05 level, 0.10 level, or any
other level between 0 and 1. A lower level oI signiIicance means that there is a lower
probability that you will make a Type I error.

e. define and interpret a 1ype I and a 1ype II error.

When we test a hypothesis, there are Iour possible outcomes:
Reject the null hypothesis when it is Ialse. This is a correct decision.
Incorrectly reject the null hypothesis when it's correct. This is known as the
Type I error. The probability oI a Type I error is designated by the Greek
letter alpha (a) and is called the Type I error rate.
Don't reject the null hypothesis when it's true. This is a correct decision.
Don't reject the null hypothesis when it's Ialse. This is known as the Type II
error. The probability oI a Type II error (the Type II error rate) is designated
by the Greek letter beta (B).

A Type II error is only an error in the sense that an opportunity to reject the null
hypothesis correctly was lost. It is not an error in the sense that an incorrect
conclusion was drawn since no conclusion is drawn when the null hypothesis is not
rejected.

A Type I error, on the other hand, is an error in every sense oI the word. A conclusion
is drawn that the null hypothesis is Ialse when, in Iact, it is true. ThereIore, Type I
errors are generally considered more serious than Type II errors. The probability oI a
Type I error (a) is called the signiIicance level and is set by the experimenter. For
example, a 5 level oI signiIicance means that there is a 5 probability oI rejecting
the null when it is true.

CFACENTER.COM 20
There is a tradeoII between Type I and Type II errors. The more an experimenter
protects him or herselI against Type I errors by choosing a low level, the greater the
chance oI a Type II error. Requiring very strong evidence to reject the null hypothesis
makes it very unlikely that a true null hypothesis will be rejected. However, it
increases the chance that a Ialse null hypothesis will not be rejected, thus lowering
power. The Type I error rate is almost always set at .05 or at .01, the latter being more
conservative since it requires stronger evidence to reject the null hypothesis at the .01
level then at the .05 level.

To reduce the probabilities oI both types oI errors simultaneously, we must increase
the sample size n.

f. define the power of a test.

Power is the probability oI correctly rejecting a Ialse null hypothesis. Power is
thereIore deIined as: 1 - B where B is the Type II error probability. II the power oI an
experiment is low, then there is a good chance that the experiment will be
inconclusive. That is why it is so important to consider power in the design oI
experiments. There are methods Ior estimating the power oI an experiment beIore the
experiment is conducted. II the power is too low, then the experiment can be
redesigned by changing one oI the Iactors that determine power.

Sometimes we use more than one test statistic to conduct a hypothesis test. In this
case we need to compute the relative power oI the test Ior the competing statistics,
and select the test statistic that is most powerful.

II you want to know more about "power oI a test", read the Iollowing (not required Ior
Level I candidates):

Consider a hypothetical experiment designed to test whether rats brought up in an
enriched environment can learn mazes Iaster than rats brought up in the typical
laboratory environment (the control condition). Two groups oI 12 rats each are tested.
Although the experimenter does not know it, the population mean number oI trials it
takes to learn the maze is 20 Ior the enriched condition and 32 Ior the control
condition. The null hypothesis that the enriched environment makes no diIIerence is
thereIore Ialse.

The question is, "What is the probability that the experimenter is going to be able to
demonstrate that the null hypothesis is Ialse by rejecting it at the .05 level?" This is
the same thing as asking "What is the power oI the test?" BeIore the power oI the test
CFACENTER.COM 21
can be determined, the standard deviation (s) must be known. II s 10 then the power
oI the signiIicance test is 0.80. (Click here to see how to compute power.) This means
that there is a 0.80 probability that the experimenter will be able to reject the null
hypothesis. Since power 0.80, b 1-.80 .20.

It is important to keep in mind that power is not about whether or not the null
hypothesis is true (It is assumed to be Ialse). It is the probability the data gathered in
an experiment will be suIIicient to reject the null hypothesis. The experimenter does
not know that the null hypothesis is Ialse. The experimenter asks the question: II the
null hypothesis is Ialse with speciIied population means and standard deviation, what
is the probability that the data Irom the experiment will be suIIicient to reject the null
hypothesis?

II the experimenter discovers that the probability oI rejecting the null hypothesis is
low (power is low) even iI the null hypothesis is Ialse to the degree expected (or
hoped Ior), then it is likely that the experiment should be redesigned. Otherwise,
considerable time and expense will go into a project that has a small chance oI being
conclusive even iI the theoretical ideas behind it are correct.

g. define and interpret a decision rule.

A decision rule is a statement oI the conditions under which the null hypothesis will
be rejected and under which it will not be rejected.

The critical value (or rejection point) is the dividing point between the region where
the null hypothesis is rejected and the region where it is not rejected. The region oI
rejection deIines the location oI all those values that are so large (in absolute value)
that the probability oI their occurrence is low iI the null hypothesis is true.

In general, the decision rule is that:
II the magnitude oI the calculated test statistic exceeds the rejection point(s),
the result is considered statisticallv significant, and the null hypothesis (H
0
)
should be refected.
Otherwise, the result is considered not statisticallv significant, and the null
hypothesis (H
0
) should not be refected.

The speciIic decision rule varies depending on two Iactors:
The distribution oI the test statistic.
Whether the hypothesis test is one-tailed or two-tailed.

For the Iollowing discussion we assume that the test statistic Iollows a standard
CFACENTER.COM 22
normal distribution. ThereIore:
The calculated value oI the test statistic is a standard normal variable, denoted
by z.
Rejection points are determined Irom the standard normal distribution
(z-distribution).

The Decision Rule Ior a Two-Tailed Test

A two-tailed hypothesis test Ior the population mean (u)is structured as H
0
: u u
0
vs
H
1
: u ~ u
0
. For a given level oI signiIicance (a), the total probability oI a Type I error
must sum to a, with a/2 in each tail. ThereIore, the decision rule Ior a two-tailed test
is:
Reject H
0
iI z -z
a/2
or z ~ z
a/2

Where z
a/2
is chosen such that the probability oI z ~ z
a/2
is a/2.

For a two-sided test at the 5 signiIicance level, the total probability oI a Type I error
must sum to 5, with 5/2 2.5 in each tail. As a result, the two rejection points
are z
0.025
-1.96 and z
0.025
1.96. These values are obtained Irom the z-table.
ThereIore, we can reject the null hypothesis iI z -1.96 or z ~ 1.96, where z is the
calculated value oI the test statistic. II the calculated value oI the test statistic Ialls
within the range oI -1.96 and 1.96, we cannot reject the null hypothesis.

The Decision Rule Ior a One-Tailed Test

A one-tailed hypothesis test Ior the population mean (u) is structured as H
0
: u u
0
vs
H
1
: u ~ u
0
. For a given level oI signiIicance (a), the probability oI a Type I error
equals a, all in the right tail. ThereIore, the decision rule Ior a one-tailed test is:
Reject H
0
iI z ~ z
a

Where z
a
is chosen such that the probability oI z ~ z
a
is a.

For a test oI H
0
: u u
0
vs H
1
: u ~ u
0
at the 5 signiIicance level, the total
probability oI a Type I error equals 5, all in the right tail. As a result, the rejection
point is z
0.05
1.645. ThereIore, we will reject the null hypothesis iI z ~ 1.645, where
z is the calculated value oI the test statistic. II z 1.645, we cannot reject the null
hypothesis.

II a one-tailed hypothesis test Ior the population mean (m)is structured as H
0
: u ~ u
0

vs H
1
: u u
0
, similar analysis can be perIormed (that is: reject H
0
iI z -z
a
).

CFACENTER.COM 23
h. explain the relationship between confidence intervals and tests of significance.

Note how the conIidence interval is related to the test statistic. They are linked by the
rejection point(s).
The conIidence interval is: |x-bar - z
(a/2)
x s/n
1/2
, x-bar z
(a/2)
x s/n
1/2
|
Recall that the test statistic is: (x-bar - u
0
) / (s/n
1/2
)

We test Ior the likelihood that the z value will be less than the test statistic. Setting up
this inequality, and rearranging, we are testing Ior: u
0
x-bar - z
(a/2)
x s/n
1/2

ConIidence intervals can be used to test hypotheses. Note that the right side oI the
equation is the leIt endpoint oI the conIidence interval. Thus, we are asking, is the
hypothesized mean less than the lower boundary oI the conIidence interval? II it is,
we reject the null hypothesis.

i. distinguish between a statistical decision and an economic decision.

Making the statistical decision involves using the stated decision rule to determine
whether or not to reject the null hypothesis. A statistical decision is based solely on
statistical analysis oI the sample inIormation. The economic or investment decision
takes into consideration not only the statistical decision, but also all economic issues
pertinent to the decision. Slight diIIerences Irom a hypothesized value may be
statistically signiIicant but not economically meaningIul (transaction costs, taxes, and
risk).

For example, it may be that a particular strategy has been shown to be statistically
signiIicant in generating value-added returns. However, the costs oI implementing
that strategy may be such that the added value is not suIIicient to justiIy the costs
required. Thus, while statistical signiIicance may suggest a particular course oI action
is optimal, the economic decision also takes into account the costs associated with the
strategy, and whether the expected beneIits justiIy implementing the strategy.

j. identify the test statistic and interpret the results for a hypothesis test about the
population mean of a normal distribution with (1) known variance or (2) unknown
variance.

CFACENTER.COM 24
When testing a hypothesis concerning the value oI a population mean, we may
conduct either a t-test or a z-test. A t-test is a hypothesis test that uses a t-statistic
which Iollows a t-distribution. A z-test is a hypothesis that uses a z-statistic which
Iollows a z-distribution (a standard normal distribution). When to use a t-test or a
z-test depends on three Iactors:
Distribution oI population: normal or non-normal.
Population variance: known or unknown.
Sample size: large or small.

Compute a significance test for the mean of a normally-distributed variable for
which the population standard deviation (s) is known.
In practice, the standard deviation is rarely known. However, learning how to
compute a signiIicance test when the standard deviation is known is an excellent
introduction to how to compute a signiIicance test when the standard deviation has to
be estimated.

(1) The Iirst step in hypothesis testing is to speciIy the null hypothesis and the
alternate hypothesis. In testing hypotheses about u, the null hypothesis is a
hypothesized value oI u. Suppose the mean score oI all 10-year old children on an
anxiety scale were 70. II a researcher were interested in whether 10-year old children
with alcoholic parents had a diIIerent mean score on the anxiety scale, then the null
and alternative hypotheses would be:
H
0
:
malcoholic
70
H
1
:
malcoholic
! 70

(2) The second step is to choose a signiIicance level. Assume the .05 level is chosen.

(3) The third step is to compute the mean. Assume 8.1.

(4) The Iourth step is to compute p, the probability (or probability value) oI obtaining
a diIIerence between M and the hypothesized value oI u (7.0) as large or larger than
the diIIerence obtained in the experiment. Applying the general Iormula to this
problem,
z (M - u)/
M
(8.1 - 7.0)/
M

The sample size (N) and the population standard deviation () are needed to
calculate
M
.
Assume that N 16 and 2.0. Then,
M
/N
1/2
0.5 and z (8.1 - 7.0)/0.5 2.2.

A z table can be used to compute the probability value, p .028.

(5) The probability computed in Step 4 is compared to the signiIicance level stated in
Step 2. Since the probability value (.028) is less than the signiIicance level (.05) the
eIIect is statistically signiIicant.
CFACENTER.COM 25

(6) Since the eIIect is signiIicant, the null hypothesis is rejected. It is concluded that
the mean anxiety score oI 10-year-old children with alcoholic parents is higher than
the population mean.

(7) The results might be described in a report as Iollows:
The mean score oI children oI alcoholic parents (M 8.1) was signiIicantly higher
than the population mean (u 7.0), z 2.2, p .028.

SUMMARY OF COMPUTATIONAL STEPS
(1)SpeciIy the null hypothesis and an alternative hypothesis.
(2)Compute M X/N.
(3)Compute
M
/N
1/2
.
(4)Compute z (M - u)/
M
where M is the sample mean and u is the hypothesized
value oI the population.
(5)Use a z table to determine p Irom z.

ASSUMPTIONS
Normal distribution
Scores are independent
is known.

Note that it is acceptable to use the z-test iI the sample is large and we don't know the
population variance.

Compute a significance test for the mean of a normally-distributed variable for
which the population standard deviation (s) is unknown.

Rarely does a researcher wishing to test an hypothesis about a population's mean
already know the population's standard deviation (). ThereIore, testing hypotheses
about means almost always involves the estimation. When is known, the
Iormula:
z (M - u)/
M

is used Ior a conIidence interval. When s is not known,
M
/N
1/2
is used as an
estimate oI
M
( is an estimate oI the standard deviation and N is the sample size).
When
M
is estimated by
M
, the signiIicance test uses the t distribution instead oI
the normal distribution.

Suppose a researcher wished to test whether the mean score oI IiIth graders on a test
oI reading achievement in his or her city diIIered Irom the national mean oI 76. The
researcher randomly sampled the scores oI 20 students. The scores are shown below.
72; 69; 98; 87; 78; 76; 78; 66; 85; 97; 84; 86; 88; 76; 79; 82; 82; 91; 69; 74

(1) The Iirst step in hypothesis testing is to speciIy the null hypothesis and an
CFACENTER.COM 26
alternative hypothesis. When testing hypotheses about m, the null hypothesis is an
hypothesized value oI u. In this example, the null hypothesis is u 76. The alternative
hypothesis is: ! 76.

(2) The second step is to choose a signiIicance level. Assume the .05 level is chosen.

(3) The third step is to compute the mean. For this example, M 80.85.

(4) The Iourth step is to compute p, the probability (or probability value) oI obtaining
a diIIerence between M and the hypothesized value oI u(76) as large or larger than the
diIIerence obtained in the experiment. Applying the general Iormula to this problem,
t (M - u)/
M
(80.85 - 76)/1.984 2.44

The estimated standard error oI the mean (s
M
) was computed using the Iormula: s
M

s/N
1/2
8.87/4.47 1.984 where s is the estimated standard deviation and N is the
sample size. The probability value Ior t can be determined using a t table.

The degrees oI Ireedom Ior t is equal to the degrees oI Ireedom Ior the estimate oI sM
which is N-1 20 - 1 19. A t table can be used to calculate that the two-tailed
probability value oI a t oI 2.44 with 19 dI is .025.

(5) The probability computed in Step 4 is compared to the signiIicance level stated in
Step 2. Since the probability value (.025) is less than the signiIicance level (.05) the
eIIect is statistically signiIicant.

(6) Since the eIIect is signiIicant, the null hypothesis is rejected. It is concluded that
the mean reading achievement score oI children in the city in question is higher than
the population mean.

(7) A report oI this experimental result might be as Iollows:

The mean reading-achievement score oI IiIth grade children in the sample (M 80.85)
was signiIicantly higher than the mean reading-achievement score nationally (u 76),
t(19) 2.44, p .025.

The expression "t(19) 2.44" means that a t test with 19 degrees oI Ireedom was
equal to 2.44. The probability value is given by "p .025." Since it was not
mentioned whether the test was one- or two- tailed, a two-tailed test is assumed.

(1)SpeciIy the null hypothesis and an alternative hypothesis.
(2)Compute M X/N.
(3)Compute s (((X - M)
2
)/(N - 1))
1/2
.
(4)Compute s
M
s/N
1/2
.
CFACENTER.COM 27
(5)Compute t (M - m)/s
M
where u is the hypothesized value oI the population
mean.
(6)Compute dI N -1.
(7)Use a t table to compute p Irom t and dI.

Assumptions
Population variance unknown.
Normal distribution oI the population iI the sample size is small, or the sample
size is large iI we don't know whether the distribution oI the population.
Scores are independent

k. explain the use of the z-test in relation to the central limit theorem.

When hypothesis testing a population mean, there are generally two options Ior the
test statistic:
t
n-1
(x-bar - u
0
)/(s/n
1/2
), when the population variance is unknown and must be
estimated Irom the sample, and
z (x-bar - u
0
)/(s/n
1/2
), when the population variance is known.

The Iirst statistic may be used iI either the sample is large (n 30 or greater), or, iI n
30, it may be used iI the sample is at least approximately normally distributed. In
most cases, this will be the statistic used, because in most practical problems, the
population variance is not known with certainty.

The second statistic is sometimes used with large sample sizes, because the central
limit theorem implies that the distribution oI a sample mean will be approximately
normally distributed as the sample size increases. Moreover, there are diIIerences
between the t-test critical values and the z-test critical values (these can be signiIicant
but get smaller with large samples). However, the t-test is still the theoretically proper
choice unless the population variance is known.

l. identify the test statistic and interpret the results for a hypothesis test about the
equality of the population means of two normally distributed populations based on
independent samples.

II it is reasonable to believe that the samples are Irom populations at least
approximately normally distributed and that the samples are also independent oI each
CFACENTER.COM 28
other, we can test whether a mean value diIIers between the two populations.

1. Test statistic Ior a test oI the diIIerence between two population means (normally
distributed populations, population variances unknown but assumed equal):
t |(x
1
-bar - x
2
-bar) - (u
1
- u
2
)| /(s
2
p
/n
1
s
2
p
/n
2
)
1/2

where s
2
p
|(n
1
- 1)s
2
1
(n
2
- 1)s
2
2
| / (n
1
n
2
- 2) is a pooled estimator oI the
common variance. The number oI degrees oI Ireedom is n
1
n
2
- 2.

2. Test statistic Ior a test oI the diIIerence between two population means (normally
distributed populations, unequal and unknown population variances):
t |(x
1
-bar - x
2
-bar) - (u
1
- u
2
)| /(s
2
1
/n
1
s
2
2
/n
2
)
1/2

where we use tables oI the t-distribution using "modiIied" degrees oI Ireedom
computed with the Iormula:
dI (s
2
1
/n
1
s
2
2
/n
2
)
2
/|(s
2
1
/n
1
)
2
/n
1
(s
2
2
/n
2
)
2
/n
2
|

A practical tip is to compute the t-statistic beIore computing the degrees oI Ireedom.
Whether the t-statistic is signiIicant will sometimes be obvious.

m. identify the test statistic and interpret the results for a hypothesis test about the
mean difference for two normal distributions (paired comparisons test).

II the two samples are not independent, the test is called paired comparison test. The
paired observations are either in or not in the same units.

Suppose we have observations on A and B, and the samples are dependent. Let di
denote the diIIerence between two paired observations, that is: di x
Ai
- x
Bi
. Let md
stand Ior the population mean diIIerence, and u
d0
is a hypothesized value Ior the
population mean diIIerence (in practice it is most likely 0). To calculate the t-statistic,
we need to Iind the sample mean diIIerence:
d-bar 1/nd
i

The sample variance, denoted by s
2
d
, is:
s
2
d
(di - d-bar)
2
/(n - 1)

The standard error oI the mean diIIerence is: s
d
-bar s
d
/n
1/2

Then t (d-bar - u
d0
)/s
d-bar
with n - 1 degrees oI Ireedom.

CFACENTER.COM 29

n. identify the test statistic and interpret the results for a hypothesis test about the
variance of a normally distributed population.

Suppose you are interested in testing whether the variance Irom a single population is
statistically equal to some hypothesized value. Let
2
represent the variance, and let
(
0
)
2
represent the hypothesized value. Then the null and alternative hypotheses
would be expressed as:
H
0
:
2
(
0
)
2
, versus H
1
:
2
~ (
0
)
2

Also note that directional hypotheses could be made instead:
H
0
:
2
(
0
)
2
, versus H
1
:
2
~ (
0
)
2
, or H
0
:
2
~ (
0
)
2
, versus H
1
:
2
(
0
)
2

Example
You are an institutional investor evaluating a hedge Iund that seeks to deliver a return
comparable to the domestic broad market equity index, while keeping the monthly
standard deviation in asset value under 5. According to data in the prospectus,
during the last 30 months the monthly standard deviation in asset value was 4.5.
You wish to test this claim statistically, using a signiIicance level oI 0.10. Assume that
returns are normally distributed and monthly asset values are independent
observations.

The hypotheses are:
H
0
:
2
0.0025, versus H
1
:
2
~ 0.0025. Note that by squaring the standard
deviation, 5 0.05, we get 0.0025.

The test statistic will be chi-squared with 30-1 29 degrees oI Ireedom.

The critical value will be Iound in the table Ior a chi-squared distribution, 29 degrees
oI Ireedom, alpha 0.10. Note that this is a one-tailed test. The critical value, Iound
in Appendix C, is 39.087.

The test statistic will be: chi-square |(29)*0.045
2
| / (0.05)
2
23.49

The test statistic is not greater than the critical value, so we do not reject the null
hypothesis. We accept that the hedge Iund is achieving its goal.

Note: II the null hypothesis had a ~ symbol in it, then we would reject iI the test
statistic were less than or equal to the lower alpha point.

The chi-square distribution is asymmetrical. Like the t-distribution, the chi-square
distribution is a Iamily oI distributions: a diIIerent distribution exists Ior each possible
CFACENTER.COM 30
value oI degrees oI Ireedom, n - 1 (n is sample size). Unlike the t-distribution, the
chi-square distribution is bounded below by 0 (no negative values).

In contrast to the t-test, the chi-square test is sensitive to violations oI its assumptions.
II the sample is not actually random or iI it does not come Irom a normally distributed
population, inIerences based on a chi-square test are likely to be Iaulty.

o. identify the test statistic and interpret the results for a hypothesis test about the
equality of the variances of two normally distributed populations, based on
independent samples.

The test statistic is F (s
1
)
2
/(s
2
)
2

Where: (s
1
)
2
and (s
2
)
2
are the sample variances Irom two samples, which have n
1
and
n
2
observations in each. The samples are random, independent oI each other, and
generated by normally distributed populations.

This test statistic will have n
1
- 1 degrees oI Ireedom in the numerator and n
2
- 1
degrees oI Ireedom in the denominator. As with the chi-squared test, the F test is not
very robust when assumptions are violated.

Like the chi-square distribution:
The F-distribution is bounded below by zero, and thereIore values oI the
F-distribution test statistic cannot be negative.
The F-distribution is asymmetrical.
The F-distribution is a Iamily oI distributions.

Unlike the chi-square distribution, the F-distribution is determined by two parameters:
the degrees oI Ireedom in the numerator, and the degrees oI Ireedom in the
denominator. Note that F(8,6) reIers to an F-distribution with 8 numerator and 7
denominator degrees oI Ireedom.

Example
You are an investor skeptical oI the value added by Jupiter Fund, an actively managed
large-cap mutual Iund. An examination oI the prospectus reveals that it has tracked its
target index Iund very closely over the past 10 years, yet it incurs a 1.51 annual
expense Iee, Iar in excess oI what one might pay to invest in a large-cap index Iund.
You wonder iI Jupiter achieves a smaller standard deviation in asset values, to justiIy
its higher costs.

You obtain monthly net asset values Ior both Jupiter Fund and the market index Ior
the past 10 years. You Iind that Jupiter Iund has a sample variance oI 0.0016 and that
CFACENTER.COM 31
the market index has a sample variance oI 0.0025. At the alpha 0.05 signiIicance
value, is the variance Ior Jupiter statistically less than that Ior the market index Iund?
Assume independence oI observations and normally distributed populations.

Solution
Our null hypothesis is actually:
H
0
: (
1
)
2
(
2
)
2
, versus H
1
: (
1
)
2
~ (
2
)
2
where the Jupiter Fund is population
2. This may seem counter-intuitive; the explanation Iollows below.

The test is a two-tailed F test, with 119 degrees oI Ireedom in both the numerator and
the denominator. Using the convention oI placing the higher variance term in the
numerator, we get an F-value oI 0.0025/0.0016 25/16 1.5625.

Note that by putting the higher variance term in the numerator, we are in eIIect saying
that the market index is population 1. II the statistic is large, then we are Iinding
evidence Ior the alternative hypothesis, that (
1
)
2
~ (
2
)
2
.

Our critical value will be Iound with the area in the right tail equal to 0.05. The table
in Appendix D contains entries Ior 60 and 120 degrees oI Ireedom; we can interpolate,
but the diIIerence is so small that we can just use the values at 120 degrees oI Ireedom.
The critical value is thus 1.35, and our test statistic exceeds this. Thus, we reject the
null hypothesis and conclude that the market index does have signiIicantly larger
variance (or alternatively, that Jupiter Fund has signiIicantly smaller variance).

p. distinguish between parametric and nonparametric tests.

In hypothesis tests, we are usually concerned with the values oI parameters, such as
means or variances. To undertake such tests, we have had to make assumptions about
the distribution oI the population underlying the sample Irom which test statistics are
derived. Given either oI these qualities, our tests can be described as parametric
tests.

All hypotheses tests that we have considered in this section are parametric test.

For example, F-test relies on two assumptions:
Populations 1 and 2 are normally distributed.
Two random samples drawn Irom these populations are independent.
The F-test is concerned with the diIIerence between the variance oI the two
populations. Variance is a parameter oI a normal distribution. ThereIore, the F-test is a
parametric test.
CFACENTER.COM 32

There are other types oI hypothesis tests, which may not involve a population
parameter or much in the way oI assumptions about the population distribution
underlying a parameter. Such tests are nonparametric tests.

A common example oI when a nonparametric test would be needed is the situation in
which an underlying population is not normally distributed. Other tests, such as a
median test or the sign test, can be used in place oI t-tests Ior means and paired
comparisons, respectively.

Another application oI nonparametric tests involves data that consists oI ranks
(ordinal-scale data). One might be ranking the perIormance oI investment managers;
such rankings do not lend themselves to parametric tests, because oI their scale.

Remember, when the data does not involve a parameter, nonparametric tests are used.
For instance, in evaluating whether or not an investment manager has had a
statistically signiIicant record oI consecutive successes, the nonparametric runs test
might be employed. Another example: iI we want to test whether a sample is
randomly selected, a nonparametric test should be used

In general, parametric tests are preIerred where they are applicable. They have stricter
assumptions that, when met, allow Ior stronger conclusions. However, nonparametric
tests do have broader applicability and, while not as precise, do add to our
understanding oI phenomena, particularly when no parametric tests can be eIIectively
used.

CFACENTER.COM 33
C. Correlation and Regression

a. define and calculate the covariance between two random variables.

In Iinance, we are oIten interested in examining the relationship between two or more
variables and developing an equation that can be used to estimate one variable based
on another.
Correlation analysis is used to measure the direction and strength oI the
relationship between two variables.
Regression analysis is used to quantiIy the relationship between the variable oI
interest and other variables.

Covariance is the average value oI the product oI the deviations oI the random
variables Irom their means. In typical use, analysts work with sample or historical
covariance, not population covariance (which is covered in section C oI study session
2).

The sample covariance oI X and Y, Ior a sample oI size n, is:

Cov(X, Y) |(Xi - X-bar)(Yi - Y-bar)|/(n - 1)

The sample covariance is the average value oI the product oI the deviation oI
observations on two random variables Irom their sample mean. Note that the
covariance oI a variable with itselI is equal to its variance.

The covariance is a variance like statistic: Whereas the variance shows the degree oI
movement oI a random variable about its expectation, the covariance shows the
co-movement oI two variables about their expectations. Covariance is a measure oI
linear association and it shows co-movement. The sign oI the covariance will tell you
whether or not two stocks generally move in the same direction; but the magnitude is
not all that helpIul. Besides, it has two major limitations:
It is measured in square units, and thereIore is diIIicult to interpret. For
example, iI the two variables are returns on two stocks, their covariance will
be in percent squared.
The value oI covariance is sensitive to the scale oI the variables.

b. define, calculate, and interpret a correlation coefficient.

The correlation coefficient (p or r) measures the degree oI correlation between two
CFACENTER.COM 34
variables.
r Cov(Xi, Yi)/(s
X
s
Y
)

Like covariance, the correlation coeIIicient is a measure oI linear association.
It is a simple number with no unit oI measurement attached.
It ranges Irom -1 to 1. II it is bigger than 0, there is a positive linear
relationship between the two variables (two variables move in the same
direction). II it is less than 0, there is a negative linear relationship between the
two variables (two variables move in the opposite direction).
The closer a correlation is to 0, the less oI a linear relationship exists between
the variables. II it is equal to 0, there is no linear relationship between the two
variables.
PerIect correlation p 1 and perIect negative correlation p -1.
It can be computed iI the means and variances oI Xi and Yi, and covariance oI
Xi and Yi, are Iinite and constant.

c. formulate a test of the hypothesis that the population correlation coefficient
equals zero and determine whether the hypothesis is rejected at a given level of
significance.

SigniIicance tests allow us to assess whether apparent relationships between random
variables are real or due to chance. II we decide that the relationships are real, we will
be inclined to use this inIormation in projections about the Iuture. For example, iI we
calculated that the sample correlation between stock returns Ior the S&P 500 and
stock returns Ior US small stocks is 0.8234 between January 1998 and June 1998, can
we conclude that it is signiIicantly diIIerent Irom 0?

For purpose oI simplicity, let's assume that both oI the variables are normally
distributed. We can then structure hypotheses as Iollows: H
0
: p 0 versus H
a
: p ~ 0
(two tailed test). We can test to determine whether the null hypothesis should be
rejected using the sample correlation p. The Iormula Ior the t-test is:
t |p x (n - 2)
1/2
| / |(1 - p
2
)
1/2
|
where p the sample correlation, n the sample size.

The degrees oI Ireedom oI the t-statistic is n - 2. All else equal, the larger the sample
size, the more likely that the null hypothesis will be rejected.

II the above sample has six observations, t |0.8234 x (6 - 2)
1/2
| / (1 - 0.8234
2
)
1/2

2.9020.

The rejection points at a speciIied level oI signiIicance are obtained by using a t-table.
As the table oI critical values oI the t-distribution Ior a two-tailed test shows, Ior a
t-distribution with n - 2 4 degrees oI Ireedom at the 0.05 level oI signiIicance, we
CFACENTER.COM 35
can reject the null hypothesis iI the value oI the test statistic is greater than 2.776 or
less than -2.776. The Iact that we can reject the null hypothesis oI no correlation when
we have only six observations is quite unusual: it Iurther demonstrates the strong
relation between the returns to the S&P 500 and returns to small stocks during this
period.

Example
Given two series oI investment returns such that r 0.925, n 12, determine whether
the two series are signiIicantly correlated at the 0.10 signiIicance level.

Solution
First, we note that this is a two-tailed test, so the signiIicance level is split between the
tails. There are n 12 pairs oI observations, and thereIore 10 degrees oI Ireedom. We
calculated r, the sample correlation coeIIicient, and it was 0.9250.

ThereIore, our test statistic equals |0.925x(10)
1/2
| / |(1 - 0.925
2
)
1/2
| 7.698.

Based on 10 degrees oI Ireedom, we reject the null hypothesis iI the test statistic is
outside the range |-1.812, 1.812|. Since it is, we reject the null hypothesis and inIer
that the population correlation is signiIicantly diIIerent Irom zero.

d. differentiate between the dependent and independent variables in a linear
regression.

Linear regression is used to quantiIy the linear relationship between the variable oI
interest and other variable(s). The variable being studied is called dependent variable
(or response variable). A variable that inIluences the dependent variable is called an
independent variable (or a Iactor). For example, you might try to explain small-stock
returns (the dependent variable) based on returns to the S&P 500 (the independent
variable). Or you might try to explain inIlation (the dependent variable) as a Iunction
oI growth in a country's money supply (the independent variable).

Regression analysis begins with the dependent variable (denoted Y), the variable that
you are seeking to explain. The independent variable (denoted X) is the variable you
are using to explain changes in the dependent variable. Regression analysis is trying
to measure a relationship between these two variables. It tries to measure how much
the dependent variable is aIIected by the independent variable. The regression
equation as a whole can be used to determine how related the independent and
dependent variables are related.

CFACENTER.COM 36
It should be noted that the relationship between the two variables can never be
measured with certainty. There always exists other variables that are unknown that
may have an eIIect on the dependent variable.

e. distinguish between the slope and the intercept terms in a regression equation.

The Iollowing regression equation explains the relationship between the dependent
variable and independent variable:
Y
i
b
0
b
1
X
i
e
i
, i 1, 2, ..., n

There are two regression coeIIicients in this equation:
The Y-intercept is given by b
0
; this is the value oI Y when X 0. It is the point
at which the line cuts through the Y-axis.
The slope coeIIicient, b
1
, measures the amount oI change in Y Ior every one
unit increase in X.
Also note the error term, denoted by e
i
. Linear regression is a technique that
Iinds the best straight-line Iit to a set oI data. In general, the regression line
does not touch all the scatter points, or even many; the error terms represent
the diIIerences between the actual value oI Y and the regression estimate.

Suppose a regression Iormula is, y
i
-23846 0.6942 x x
i
, where the large constant
and the x terms are on a date scale Ior a spreadsheet program (e.g., Sept 1, 1997
35674).

In the regression equation above, the b
1
term, 0.6942, represents the slope oI the
regression line. The slope, oI course, represents the ratio oI the vertical rise in the line
relative to the horizontal "run." The slope and the intercept (b
0
, here -23846) represent
parameters calculated by the regression process. The process oI linear regression
calculates the parameters as those that minimize the squared deviations oI the actual
data values Irom the estimated values obtained using the regression equation. The
process oI determining these parameters involves calculus.

Linear regression involves Iinding a straight line that Iits the scatter plot best. To
determine the slope and intercept oI the regression line, one must either use a
statistical calculator, a soItware program, or calculate it by hand. Typically, the analyst
will not have to calculate regression coeIIicients by hand. However, it is possible to
do so.
For regression equations with only one independent variable, the estimated
slope, b
1
, will equal the covariance oI X and Y divided by the variance oI X.
b
1
Cov(X,Y) / (
x
)
2
Cov(X,Y)/Var(X)
CFACENTER.COM 37

The intercept parameter, b
0
, can then be determined by using the average
values oI X and Y in the regression equation and solving Ior b
0
.
b
0
(hat) Y-bar - b
1
(hat) x X-bar

The "hat" above the b terms means that the value is an estimate (in this case, Irom the
regression).

The equation that results Irom the linear regression is called linear equation, or the
regression line.
Regression line: Y-bar
i
b
0
(hat) b
1
(hat) X
i

Regression equation: Y
i
b
0
b
1
X
i
e
i
, i 1, 2, ..., n

The linear equation is derived by applying a mathematical method called the least
squares regression, also known as the sum of the squared errors: the sum oI the
squared distances oI all the points in the observation away Irom the mean.

Note that we never observe the actual parameter values b
0
and b
1
in a regression
model. Instead we observe only the estimated values b
0
and b
1
. All oI our prediction
and testing must be based on the estimated values oI the parameters rather than their
actual values.

AIter you calculate your b
0
and b
1
, test their signiIicance. Also note that the regression
analysis does not prove anything; there could be other unknown variables that aIIect
both X and Y.

f. list the assumptions underlying linear regression.

Classical normal linear regression assumptions:
Linear Relation: a linear relation exists between Yi and Xi. The relation is
linear in the parameters a and B.
Normality: Ior any value x, the error term has a normal distribution.
Zero mean: Ior any value x, the expected value oI the error term is 0. That is,
E(ei) 0.
Homoscedasticity: The variance oI ei, denoted s
2
, is the same Ior all x.
No serial correlation: the error terms are independent oI each other. It is
uncorrelated across observations.
Independence of ei and xi: the error terms ei are independent oI the values oI
the independent variable X.

CFACENTER.COM 38
g. define and calculate the standard error of estimate and the coefficient of
determination.

II all the points lie on the regression line, the dependent variable can be predicted with
100 accuracy by using the regression line. In practice, however, the linear
regression line that runs through the data usually misses the actual data points,
producing non-zero error terms. Standard Error of Estimation (SEE) is the standard
deviation or the dispersion about the regression line. It measures dispersion oI values
around regression line.
The smaller the SEE, the more accurate the regression line to predict the value
oI the dependent variable
It is very much like the standard deviation Ior a single variable, except that it
measures the standard deviation oI the residual term in the regression.
II the actual values Ior the observations are close to the regression line, it
means that the relationship between the dependent and independent variables
are strong. However, it does not tell us how well the independent variable
explains variation in the dependent variable.

The Iormula Ior the standard error oI estimate Ior a linear regression model with one
independent variable is:
|(Yi - a - B Xi)
2
/(n - 2)|}
1/2

n - 2 is called the degrees of freedom: it is the denominator needed to ensure that the
estimated standard error oI estimate is unbiased.

Note that the errors are actually squared, averaged, and then the square root is taken.
Consequently, large outliers will tend to have a greater impact on the value oI the
standard error than iI a simple average was taken. Note too that the "averaging" is
done by dividing by (n - 2). This is because the linear regression estimates two
parameters, so we divide by (n - 2) to make sure the calculated standard error oI
estimate is unbiased.

In Iinance world the standard error oI estimate is also called unsystematic variation.

The coefficient of determination is a measure oI the proportion oI total variance in
the dependent variable (Y) that can be explained by variation in the independent
variable (X). It is a measure oI the goodness oI Iit oI the regression line.
R
2
Explained variation/Total variation 1 - Unexplained variation/total variation

The total variation in the independent variable is deIined as the sum oI the
squared diIIerences between actual Y-values and their mean: Total variance
(Y
i
- Y-bar)
2
.
The explained variation is deIined as the sum oI the squared diIIerences
between predicted Y-values and the mean oI actual Y-values: Explained
variation (Y-hat
i
- Y-bar)
2
.
CFACENTER.COM 39
The unexplained variation is simply the sum oI squared errors (SSE):
Unexplained variation (Y
i
- Y
i
(hat))
2
.

Note that the higher the R
2
, the better. R
2
values range Irom 0 to 1.

The easiest way to calculate the coeIIicient oI determination is to square the
correlation coeIIicient, iI that is known. Thus, the coeIIicient oI determination is oIten
denoted R
2
. This method, however, only works when there is just one independent
variable. When there are two or more independent variables in linear regression, we
need to use above Iormulas.

h. calculate a confidence interval for a regression coefficient.

Many times it is desirable to check the relative conIidence we have in our estimates oI
regression parameters. The estimated value may be diIIerent Irom the actual value, so
we construct a conIidence interval around the estimated value. The conIidence
interval is a range in which we would expect to Iind the actual value oI the population
parameter, with a given probability.

Aside Irom the estimated parameter value itselI, the two key measures needed to Iorm
a conIidence interval are the standard error oI the parameter and the critical value Ior
the t-distribution associated with the t-test oI statistical signiIicance. Keep in mind
that the t-distribution requires that the number oI degrees oI Ireedom be known. For a
linear regression with two parameters estimated (the two parameters are the slope and
intercept), the number oI degrees oI Ireedom is (n - 2), where n is the number oI
observations. (Generally, the number oI degrees oI Ireedom equals the number oI
observations less the number oI parameters estimated.)

For a parameter bi, the conIidence interval will be: bi or- t
c
x s(
bi(hat)
)
Where:
t
c
critical t-value
s(
bi(hat)
) standard error oI the parameter bi(hat). The smaller the standard
error oI the estimated coeIIicient, the tighter the coeIIicient interval.

Example
Suppose you are estimating the CAPM beta Ior All-Trick, a publicly traded brokerage
Ior day-traders. You use 32 months oI data and regress the stock perIormance oI
All-Trick against that oI the overall market. You Iind that the slope coeIIicient
estimated Irom the regression (b
1
) equals 1.98, with a standard error oI 0.33. Find the
CFACENTER.COM 40
95 conIidence interval Ior the beta oI All-Trick.

Solution
The example provides us all the data we need except the critical value Ior t. Since the
conIidence interval will exclude data in the extremes oI both tails, we look up Ior
t-values based on signiIicance level oI 0.05/2 0.025. The degrees oI Ireedom will be
32 - 2 30, since the regression will estimate two parameters. The critical t-value Ior
30 degrees oI Ireedom and a 0.025 level oI signiIicance is 2.042.

ThereIore, using the Iormula above, our 95 conIidence interval will be: 1.98 or-
(2.042 x 0.33) 1.98 or- 0.6739 |1.3061, 2.6539|.

We are 95 conIident that the true beta lies within this range.

i. identify the test statistic and interpret the results for a hypothesis test about the
population value of a regression coefficient.

Testing a Hypothesis about a Regression Parameter

Suppose we wish to have more inIormation about this estimated parameter, such as
the likelihood that its true value is less than 1.50. To answer this question, we turn
again to the t-test oI signiIicance. We use the test statistic:

t (bi(hat) - bi) / bi(hat)

Again, this statistic has n - 2 degrees oI Ireedom Ior a linear regression with one
independent variable. We compare the t-statistic with the critical value Ior t, and iI the
statistic exceeds the critical value, we reject the null hypothesis.

Note that Ior both coeIIicients, the t-test and the conIidence interval approach lead to
the same conclusions.

j. interpret a regression coefficient.

Keep in mind that when perIorming regression with just one independent variable, the
regression coeIIicient is nothing more than the slope oI the regression line. When
CFACENTER.COM 41
regressing excess stock returns, it also has a Iinancial interpretation: it is the stock's
beta. The beta is a type oI equity perIormance multiplier, because it gives a measure
oI how much a rate oI return changes relative to the risk Iree rate and overall market
return.

Example
Use the Capital Asset Pricing Model to predict the return on GE stock, given the
expected market return. Assume the risk-Iree rate is 5 per year, GE's alpha and beta
are 0 and 1.35 respectively, and the market return is:
a) 10, and
b) -10

Solution
a) Given the data above, and the Iormula E(R
GE
) alpha
GE
R
I
beta
GE
x |E(R
m
) -
R
I
|, then we would expect GE stock to return 0 5 1.35 (10 - 5) 11.75.
b) Given the data and Iormula above, we would expect GE stock to return 0 5
1.35 (-10 - 5) -15.25.

So a beta greater than 1.00 means the stock is more volatile than the market as a
whole (and the regression line oI market return vs. stock return will be steeper).
Conversely, a stock with a beta oI less than 1.00 will be less sensitive to market
movements, and the return will be dampened or more Ilat. II beta equals 1.00, the
CAPM Iormula indicates the asset is expected to have the same return as the market
as a whole.

k. calculate a predicted value for the dependent variable, given an estimated
regression model and a value for the independent variable.

Suppose we have the Iollowing regression equation Ior the Ivory Tower Mutual Fund.
Y
t
0.0009 0.6154 x X
(1,t)
0.3976 x X
(2,t)

Where:
X
(1,t)
return on the small-cap value index
X
(2,t)
return on the small-cap growth index

Suppose Iurther that we know that in a given month, the small-cap value index
returned -1.2 and the small-cap growth index returned -1.9. What is the predicted
return Ior the Ivory Tower Mutual Fund?

The return is simply 0.0009 0.6154 (-0.012) .3976 (-0.019) -1.4.
CFACENTER.COM 42

Note that although the prediction oI an individual value Yi and the estimate oI the
mean value E(Yi,Xi) are the same Ior a given value Xi, the sampling errors associated
with the two predictions are diIIerent! The estimate oI the mean value oI Yi does not
require an estimate oI the random error ei. The conIidence interval Ior the individual
Y is always wider that that Ior mean value.

l. calculate and interpret a confidence interval for the predicted value of a
dependent variable.

We oIten wish to have a conIidence interval Ior the dependent variable Ior which we
are perIorming the regression. Obtaining a conIidence interval Ior the dependent
variable is a bit more complicated because there are multiple sources oI variation.
First, there is the variation Irom the standard error oI estimate (SEE) in the regression
equation. A second source oI uncertainty comes Irom the variation in the estimate oI
the regression parameters themselves. II these were known with certainty, then the
predicted values oI the dependent variable would have variance equal to the squared
standard error oI estimate. However, the parameters themselves are not known with
certainty.

The Iormula Ior the variance in the prediction error, (s
I
)
2
, oI Y, is:

(s
I
)
2
s
2
x 1 1/n |(X - X-bar)
2
| / |(n - 1) x (
x
)
2
|}

Where:
s
2
squared standard error oI estimate
n number oI observations
X value oI the independent variable used Ior the speciIic prediction oI Y
X-bar mean oI the independent variable across the observations
(
x
)
2
sample variance oI the independent variable

Once the variance in the prediction error, (s
I
)
2
, is known, the conIidence interval Ior
the dependent variable Y is constructed in a very similar way to the construction oI
conIidence intervals around parameters. The conIidence interval will be: Y-hat or- (t
c
)
x (s
I
)

Where Y-hat is the predicted value oI Y, based on a particular value oI X, t
c
is the
critical value Ior the t-statistic Ior a signiIicance level oI alpha, and s
I
is the standard
error oI the predicted value.

CFACENTER.COM 43
Example
Suppose we are predicting the excess return on GE stock Ior the next month using the
Iormula: R
GE
- R
I
alpha
GE
beta
GE
x (R
m
- R
I
) error
You are given the Iollowing data regarding 24 monthly observations oI the excess
return on GE stock and on the S&P 500 over the risk-Iree rate:
The mean excess return on the S&P 500 during the observation period was -0.6751.
The variance oI the excess return on the S&P 500 during the observation period was
0.2453.
The standard error oI estimate is 0.0622.
You expect the excess return on the S&P 500 to be 0.1580 next month.
The alpha Ior GE stock is 1.68; the beta Ior GE stock is 1.3487.
Find the 95 conIidence interval Ior the excess return on GE stock next month.

Solution
First, we predict the value oI the dependent variable Ior next month: Y-hat R
GE
- R
I
,
the excess return on GE stock. Using the Iormula and data above we have: 0.0168
1.3487(.00158) 1.893

Second, compute the variance oI the error in this prediction. (s
I
)
2
s
2
x 1 1/n |(X
- X-bar)
2
| / |(n-1)x (s
x
)
2
|} 0.0622
2
x 1 1/24 |(0.0158-(-0.006751))
2
| / |(24 - 1)
x (0.002453)| 0.4035

The standard deviation oI this Iorecast error is the square root oI this number, or
6.3522.

Third, Iind the critical value Ior the t-statistic. We will have 22 degrees oI Ireedom,
and the value Ior a 95 conIidence interval will be 2.074.

Fourth, calculate the prediction interval. It will be: 1.893 or- 2.074(6.3522)
|-11.28, 15.07|

This is a Iairly large interval Ior just one month oI excess return. Clearly, the large
standard deviation in Iorecast error is a big Iactor in the size oI the interval. It is also
due in part to having only 24 observations. By collecting a greater number oI
observations, we could probably lower the standard deviation oI Iorecast error (and,
slightly, the critical value Ior t).

m. describe the use of analysis of variance (AAOJA) in regression analysis.

When working with regression analysis, we oIten wish to quantiIy the accuracy oI our
CFACENTER.COM 44
regression estimates. Two ways oI doing this are the use oI conIidence intervals and
signiIicance testing oI the regression coeIIicients.

Another way is to examine all the sources oI variability within the regression, and
classiIy them according to their source. This method is called analysis of variance
(ANOVA), and it can help in identiIying which independent variables are oI
signiIicant value to the regression model. Compared with the coeIIicient oI
determination, an ANOVA procedure provides more details about the sources oI the
variations.

Typically, the ANOVA procedure is perIormed using statistical soItware packages.
The output oI the ANOVA procedure is an ANOVA table.

Here is an example oI an ANOVA table:

ANOVA dI SS MS F
Regression 1 0.1026 0.1026 26.5547
Residual 22 0.0850 0.0039
Total 23 0.1877

CoeIIicients Standard Error t Statistic
Alpha (intercept) 0.0168 0.0128 1.3149
Beta (coeIIicient) 1.3487 0.2617 5.1531

One test statistic that is helpIul in identiIying signiIicant variables is the F-statistic.
The F-statistic can be a blunt tool in multiple regression, in that it tests the null
hypothesis that all oI the independent variables are equal to zero. In simple linear
regression, however, it simply tests whether the slope oI the one independent variable
is zero: H
0
: b
1
0 vs. H
a
: b
1
~ 0.

To develop the F test statistic, we need several items:
The total number oI observations, n.
The number oI parameters estimated (in simple linear regression, this is two:
the intercept and the slope oI the regression line).
The sum oI the squared errors (SSE), also known as the residual sum oI the
squares: SSE |Yi - Yi(hat)|
2
.
The regression sum oI the squares (RSS), which is the sum oI the squared
deviations oI the regressed values oI Y around the average value oI Y: RSS
|Yi(hat) - Y-bar|
2
.

The F-statistic Ior one independent variable will be: F |RSS/1| / |SSE/(n - 2)|
Mean regression sum oI squares / Mean squared error

Note that the F-statistic will have 1 degree oI Ireedom in the numerator (again, when
CFACENTER.COM 45
there is only one independent variable) and (n - 2) degrees oI Ireedom in the
denominator.

A large test statistic (in absolute value) implies rejection oI the null hypothesis and
thereIore a non-zero value Ior the slope oI the regression line. A large F-statistic also
implies that the regression model explains much oI the variation in the dependent
variable. However, Ior simple linear regression with one independent variable,
F-statistics are rarely used, because they contain the same inIormation as the t-statistic.
In Iact, the F-statistic is simply the square oI the t-statistic in such regressions (note,
this is not true Ior multiple regression).

n. define and interpret an F-statistic.

F-test is an important statistical test conducted in ANOVA. The F-statistic tests
whether all the slope coeIIicients in a linear regression are equal to 0. That is, the
hypotheses are structured as Iollows: H
0
: b
1
b
2
... b
k
0, and H
a
: at least one b
i

~ 0. II the null is not rejected, all the slope coeIIicients are equal to 0, and thereIore
all slope coeIIicients are unimportant Ior predicting Y. We can see that F-test measures
how well the regression equation explains the variation in the dependent variable.

The F-test is based on an F-statistic:
F Mean regression sum of squares / Mean squared error

The ANOVA table can be used to compute the F-statistic.

II the regression model does a good job oI explaining variation in the dependent
variable, then this ratio should be high. That is, the explained regression sum oI
squares per estimated parameter will be high relative to the unexplained variation Ior
each degree oI Ireedom.

In a regression with one independent variable, this is a test oI the null hypothesis H
0
:
B 0 against the alternative hypothesis H
a
: B
1
0.

In such regressions, the F-statistic is the square oI the t-statistic Ior the slope
coeIIicient.

CFACENTER.COM 46
o. discuss the limitations of regression analysis.

The most obvious limitation oI regression analysis is that in the Iield oI investments,
the estimated parameters and other relationships have a tendency to change through
time. Thus, the relationships between variables Iound during one period may not
persist through a Iuture period. For example, the betas estimated Ior stocks tend to
vary and driIt over time. Also, the correlations between currencies Iluctuate over time.

Another limitation oI regression analysis is that any proIitable discoveries tend to be
arbitraged away in Iuture periods, assuming that the relationships even continue into
those Iuture periods. Other analysts may have discovered the same thing, and be
acting on it at the same time. Moreover, just trying to act on a pricing disparity tends
to change the market price oI whatever is being bought or sold, so any arbitrage
opportunity may disappear quickly.

A third and very important limitation is that the key quantitative variables oI the
investment world (asset prices, correlations, interest rates, etc.) do not always behave
in a way that Iits neatly into a statistical model. Models that require independence or
normal distributions may not be good Iits Ior many investment phenomena, and in
those cases, the analysis must take into account how robust the models are to varying
degrees oI assumption violation.

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Study Session 2 Quantitative Methods (II)

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