Table of Contents

Q1. ........................................................................................................................................................... 2
Q2. ........................................................................................................................................................... 5
Q3. ........................................................................................................................................................... 5
Q4. ........................................................................................................................................................... 7
Q5. ........................................................................................................................................................... 8

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Q1. Suppose you have 5-yearannual data on the excess returns on a fund managers portfolio

(fund ABC) and the excess returns on a market index (where rABC is the return on fund ABC, rf is
the risk-free rate and rM is the return on the market index):
Excess return on fund ABC

Year t

rABC ,t rf ,t

Excess return on
market index

rM ,t rf ,t

14.0

16.0

32.0

21.7

11.6

6.0

21.2

16.2

17.4

11.0

(a) What is the estimated alpha ( ) for Fund ABC?

(b) Given the data in question (a), what is the estimated beta ( ) of Fund ABC?
(c) Suppose that the unbiased estimator of the standard deviation of the disturbance ( s) is 5.1. What
is the nearest value to the standard errors of the estimated CAPM alpha ( ) of Fund ABC

(d) The estimated alpha () and beta( ) of a rival fund, Fund DEF, are 2.3 and 3.1, respectively. If
the expected market risk premium is 12%, what would we expect the excess return of Fund DEF to
be?
Answer:

(a) Plotting the points to study noise and co-integration of the two series:

Series-Plot
35.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0

Excess return on fund ABC

rABC ,t rf ,t

Excess return on
market index
rM ,t rf ,t

We assume at this stage that the data is sufficiently noise reduced besides further differencing or
studying the stationarity could potentially reduce number to observations to 4 or 3 observations.
We also see a positive co-integration between market excess returns and that on Fund ABC.

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Estimated model:

, = + , ,,

Verbose Explanation:
We Estimate, Excess Returns of stock ABC for a period i on its own alpha, the estimate of which is
, and excess return on Market over Risk free rate for the same period i, ,, .

We use Ordinary Least Squares (OLS) also known as linear regression and Linear Projection
to estimate our coefficients.
estimated alpha ( ) for Fund ABC , = 3.2739

(b) Estimated beta () of Fund ABC,

, = 1.126

SUMMARY OUTPUT

Regression Statistics
Multiple R
0.83574
0.69846
R Square
1
Adjusted R
0.59794
Square
7
Standard
5.07134
Error
1
Observation
s
5
ANOVA
df

SS

Regression

178.7165

Residual
Total

3
4

77.1555
255.872

Coeffici
ents

Standard
Error

Intercept

3.27392

Excess
return on
market
index
rM ,t - rf ,t

1.12595
8

MS
178.7
165
25.71
85

F
6.948
948

6.467439

t Stat
0.506
216

Pvalue
0.647
562

0.427132

2.636
086

0.077
917

Page 3 of 9

Significa
nce F
0.077917

Lower
95%
-17.3084

Upper
Lower
95%
90.0%
23.856
2 -11.9463

Upper
90.0%
18.4941
6

-0.23337

2.4852
84

2.13115
5

0.12076

(c)
Year
t

Excess return on fund

ABC
rABC ,t rf ,t

1
2
3
4
5

14.0
32.0
11.6
21.2
17.4
Sum (Xi^2)
Sum(Xi - Xbar)^2

Year
t

1
2
3
4
5

Excess return
(xion
xbar)^2
market index
rM ,t rf ,t
1.8
16.0
7.5
21.7
-8.2
6.0
2.0
16.2
-3.2
11.0
1146.33
141.0

Excess return on fund ABC

rABC ,t - rf ,t

Excess
return
on
market
index
rM ,t rf ,t
16.0
21.7
6.0
16.2
11.0
1146.33

14.0
32.0
11.6
21.2
17.4
Sum (Xi^2)
Sum(Xi - Xbar)^2

(xi-xbar)^2

1.8
7.5
-8.2
2.0
-3.2
141.0

Variance of alpha, with true variance known,

(|) =

1146.33
=
26.01 = 211.4613
141.0

s.e. (|) = 211.4613 14.542

(d) Expected Excess Return of Fund DEF = , = 2.3 + 3.1 12 = 39.1%

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Q2. You are told that the return of a stock is unrelated to the movement in the
market, (i.e. the stock has zero systematic risk). You calculated the beta and its
standard deviation using 40 quarterly observations on the stocks return and
found out that its beta is 0.355 and the standard deviation is 0.20. Write down
the null and alternative hypotheses to test the claim and test the
hypothesis against a two-sided alternative.
Answer:
Null Hypothesis (Two-Tailed): Beta = 0. There is no significant positive
correlation between the excess returns on the stock and that on the market.
Alternative Hypothesis: Beta 0. There is significant positive correlation
between excess returns on the stock and that of the market.
0 : = 0

0.

Testing:
We compute the values of Beta at 99 % Confidence Interval. We use the
studentized t-distribution. We studentize our Beta given mean of zero, and
specified value of s.d. and number of observations.
We also compute the critical t values (Upper value would be relevant here) of
the studentised t distribution for 40-1-1= 38 degrees of freedom and our
confidence interval.
Decision Rule:
If the studentized Beta observed falls outside this Confidence Interval, we
Reject the Null Hypothesis, in favour of the alternate Hypothesis.
If the studentised Beta observed is within the estimated 99% CI, we fail to
reject the null Hypothesis, and conclude that Beta is not significantly different
from zero.

Studentised beta, =

.3550
.2

= 1.775 (40 1 1) = (38)

Inverse .01 (=1-.99) Critical Value of t = 2.7116

Also Testing at 95 % CI.

Inverse .05 (=1-.95) Critical Value of t = 2.0244

We fail to reject the Null hypothesis at both 95 and 99 % Confidence Intervals.
is not significantly different from zero.

Q3. You are estimating the following econometric model under the restriction
that 3 + 4 = 1. A regression carried out on a sample of 120 quarterly
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observations produces the value of 145.45 for restricted residual sum of squares
and a value of 109.50 for the unrestricted residual sum of squares. Perform the
test on this restriction and state your conclusion.
yt = 1 + 2x2 + 3x3 + 4x4 + ut
Answer:
H0: 3 + 4 = 1
HA: 3 + 4 1.
We compute the F- Statistic:

( e e ) q
F=
( e ) (n k 1)
2*

* refers to the restricted model

q is the number of constraints
in this case the number of constraints = 1
n - k -1 is the df of the unrestricted model = 120-4-1 = 115.

FR =

145.45109.5
109.5
115

= 37.7557 (1,115)

Decision Rule:
Reject H0, if FR > F*(.05,1,115). Fail to reject otherwise.
F*(.05,1,115) = 3.923599.
Inference:
Since FR > F*, we reject H0, i.e., we reject that 3 + 4 = 1.
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Q4. You have estimated the following model. Calculate the t-statistics for parameters and compare
them with the R2 statistics. Do you see any problem with this estimation? If you
see a problem, how would you go about addressing it?
yt = 0.75 + 0.252x2t 0.751x3t; R2 = 0.96 ;
se(constant) = 0.355; se(x2t ) = 0.150 and se(x3t) = 0.690

Answer:
intrcpt
x2
x3
Estimate
0.75
0.252
0.751
se.
0.355
0.15
0.69
t
2.112676
1.68 1.088406
t-crit ( 5% Sig.), 47 Obs
44
1.68023
1.68023
1.68023

For large number of Observations:

Estimate
se.
z
z-crit ( 5% Sig.)

intrcpt
x2
x3
0.75
0.252
0.751
0.355
0.15
0.69
2.112676
1.68 1.088406
1.644854 1.644854 1.644854

We have a Large R- Squared, which says that our Model explains 96 % of the observed
variance in explanatory variable, large relative value of multipliers which turn out to be
insignificant. Assuming upto 47 observations, none of the variables are significant. Even in
the extreme, 50 % of the theoretically useful variables with high Relative value of Estimates
of the coefficient of variables that turn insignificant. Figures marked in red indicate
insignificance.
High R-squared and Low predictive power of individual variables could arise from MutliCollinearity, apart from Overfitting which is not likely the case, because we have
only two variables.
Sometimes, Overfitting that takes place (High R-squared) may not be an issue, in
case we are on predictive considerations. The issue is when we want to drop
variables from a model, to find which factors need to be controlled. Multicollinearity
will by definition inflate both Betas and R^d. So .96 is not High R-squared in this
context.
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At times with high Multi-collinearity which we measure in terms of VIFs, the

algorihms might yield inaccurate estimates.
VIFs must be computed.
Then, calculate the VIF factor for factor i with the following formula:
1

VIFi=12

where R2i is R2 of the regression equation in step one, with on the left hand side, and all
other predictor variables (all the other X variables) on the right hand side.
If VIF >> 5 (> 5 is multicollinearity), the cut is placed arbitrarily at say 5, 15, we need
remedial regressions.
One of these would be to Club Variables into a composite variable based on some
regression criterion.
The second would be to Add more data or variables that can linear the regression.
A few softwares drop the last variable with a high linear correlation (>.6 is a popular
choice), this has to do with the algorithm they are using.
There are ways to control Variance and Censor the Betas which is often a concern:
Ridge Regression is a way of censoring the betas.
Principal Component Analysis may be used.
Partial Least squares.
Structural Equation Modelling wherein a set of equations are estimated simultaneously.
The set of equations will include main equation.
An equation where there is collinearity within variables or Endogeniety. This will require in
practice Large data due to reduced degree of freedom.

Q5.

In a regression model with two explanatory variables and a sample of 50 observatories, the
estimated errors produce a correlation coefficient of 0.4. Calculate D-W (Durbin-Watson) test
statistic and test for the absence of autocorrelation in the error terms. Make sure that you state the
null and alternative hypotheses.

Answer:
H0: There is Positive Correlation in residuals.
HA: There is No Positive Correlation in residuals.
To test for positive autocorrelation at significance , the test statistic d is compared to
lower and upper critical values (dL, and dU,):

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If d < dL,, there is statistical evidence that the error terms are positively
autocorrelated.

If d > dU,, there is no statistical evidence that the error terms are positively
autocorrelated.

If dL, < d < dU,, the test is inconclusive.

From Durbin Watson Table (k=2, n=50) -> du 1.46, dl 1.63.

D = 2- CORRELATION =1.6
Since 1 .46< 1.6 <1.63, THE TEST IS INCONCLUSIVE.

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