Lecture 4

CAPM and Hypothesis testing

Don’t forget to take a look at Berndt!
Sections 2.5 and 2.6 are useful!

OLS:Hypothesis Testing
• In practice we are almost always working with a
small sample of data. Unfortunately, what we
generally care about is what is going on in the
population.
• How do we make inferences about the population
from estimates that are based on a small sample of
data?
• Answer: Hypothesis Testing
• Before we can talk about Hypothesis Testing though
we need to make formal the distinction between
population and sample. 2

OLS: Hypothesis Testing

• Up to now we have talked about b, the OLS
estimated coefficient vector.
• When doing hypothesis testing we think of b being
an estimate of a population vector of coefficients β.
• In the population we think of the following structure
as holding: y=X β+ε.
• This distinction is very important for hypothesis
testing. When doing hypothesis testing we are
asking about the probability of certain facts holding
in the population given a particular realization.
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 OLS Hypothesis Testing
• Hypotheses about individual regression coefficients:
The t-ratio.
• Under the null hypothesis that b k=βk the t-ratio
given by (Hayashi eqn. (1.4.5)):
bk − β
tk = k

c
s ( x ' x ) −1
2
h kk
• is distributed as t with n -K degrees of freedom.

Hypothesis Testing
• To use the t -ratio to test a null hypothesis about one
of the estimated coefficients(see Hayashi p37-38):
° Construct the t -ratio using the hypothesized population
value β k.
° Call the gauss function cdftc(t k,n-k)
° multiply the response by 2.
° The result is the p-value, p=cdftc(tk ,n-k)*2. It has the
following interpretation:

Pr( − tk < t < tk ) = 1 − p

Hypothesis Testing
• Define α, to be the critical level at which you are
performing the test e.g. 0.05. Then:
° fail to reject the null hypothesis if p > α
° reject the null hypothesis if α ≥ p
• Intuition. When p is small the t-ratio is surprisingly
large for a random variable that is distributed t. Thus
the smaller the p the stronger the rejection.
• Often times people are interested in looking at the
hypothesis that the estimated coefficients from a
regression are different from zero. This is a
particular case of the t-ratio. 6

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 Hypothesis Testing
• If the null hypothesis is βk =0 then the t -ratio is given
by:
bk
tk =
2
c
s ( x ' x)
−1
h kk

• Often times researchers use a t-ratio of 2 as a

benchmark. If the t-ratio shown above is bigger
than 2 they say that b k is significantly different from
zero. (implicitly they are setting n-k (degrees of
freedom) to a big number and using a 5% critical
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value.)

Back to the CAPM

• In the previous lecture we demonstrated that the
CAPM implies that there is a linear relationship
between risk and return. Now we want to see how
we can use the statistical tools we have just
described to parameterize the CAPM. Before we do
this define the investment beta for stock j as:

Beta j = σ jm / σ 2m
• This expression summarizes the covariance of firm
j’s risk premium with the market portfolio risk
premium divided by the market variance. 8

More CAPM
• Suppose that betaj=2. This means that if the market goes up
or down by 1% on average security j goes up or down by
2%.
• An “aggressive” stance corresponds to holding a portfolio
of stocks with betas greater than one.
• A “defensive” stance corresponds to holding a portfolio of
stocks with betas less than 1.
• The investment beta for a portfolio of stocks is given by:
n
Beta qm
= ∑ w iq
⋅ beta im
i=1

• where wiq is the portfolio weight of security i.

9

3
 More CAPM
• The CAPM theory tells us:

rj − r f = σ d j /σ m i ⋅ (rm − rf )
• We can use OLS to estimate the proportionality
factor σj /σm in the following way:
rj − rf = α j + β j (rm − rf ) + ε j
• What data do we need to estimate this regression?

10

More CAPM
• How does OLS estimate βj?
° OLS estimates: b j = Cov (rj − rf , rm − rf ) / Var( rm − rf )
° But notice this is the same object as the investment beta
defined above!
° This implies that σj /σm =betaj
° How do we interpret α?
• According to the CAPM α should be zero.
• Suppose α is estimated to be .67 using monthly data.
• This means that if the market were expected to earn zero. This
asset (portfolio) would earn .67% per month or about 8% per
year.
• This is one way to evaluate performance of a portfolio. Check
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to see the sign and magnitude of α.

More CAPM
• Another related measure of portfolio performance is the Reward t o
VOLatility ratio.
• Consider:

rp − r
=
f
R V O L
β
p
p
• RVOLp has the following properties.
° If RVOL p is greater than the average market risk premium: r − r
m f
then portfolio p has outperformed the market.

° If RVOL p is less than the average market excess return portfolio p

has under performed the market.
° This measure of performance is similar to α but not the same12.

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 More CAPM
° When α is positive RVOL is greater than the average market risk
premium.
° When α is negative RVOL is less than the average market risk
premium.
° However, the two measures of performance rank alternative
portfolios differently.
° Both measures of performance are appropriate for an individual
who has lots of other portfolios besides this one.
• These measures are not appropriate for an investor whose
entire savings are tied up in the portfolio being evaluated.
These statistics do not take into account risk that is unique
to this portfolio. Only market risk appears in the
denominator not total risk. (total risk=market risk + unique
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risk).

More CAPM
• A more suitable measure of portfolio performance
for a small investor who is holding only portfolio p
is the Reward to VARiability ratio (Sharpe Ratio):

rp − r f
RVARp =
σp

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MORE CAPM
• Criticisms of these measures of portfolio peformance.
• α and RVOL require the use of a market portfolio. Small
changes in the market portfolio can have a big effect on the
rankings. For instance measuring the market value with
alternatively a value weighted index and the S&P 500 give
different rankings.
• How do we distinguish skill from luck?
• How do you deal with churning?
° Dollar-weighted returns
° time-weighted returns (see e.g. Sharpe and Alexander,
Investments)
15

5
 More OLS
• The mechanics of influential observations.

(i )
− b = −
FG 1 IJ ( X ' X ) −1
b
H1− p K
i
x i ei

or,
(i )
= −
FG 1 IJ ( X ' X ) −1
x i ei + b
b
H1− p K
i

pi = ( X ( X ' X ) − 1 X ' ) i i

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GAUSS
• Some useful gauss commands:
• meanc(x) (calculates the mean of each column of x)
• stdc(x) (calculates the std. deviation of each col. of
x)
• invpd(x) good for calculating the inverse of X’*X
• X=ones(rows(X),1)~X ; (add a column of ones to
X).
• Diag(x) (returns the diagonal elements of a square
matrix )
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More Gauss

i = 1;
n = rows(X);
k = rows(b);
b m = zeros(k, n);
p = d i a g ( X * invpd(X'*X ) * X ' ) ;
d o w h i l e i <= n ;
b m [ . , i ] = 1 / ( 1 - p[i]) * i n v p d ( X ' * X ) * X [ i , . ]'*e[i] + b ;
i = i + 1;
endo;
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6
 Joint Hypothesis tests
• More on hypothesis testing in the linear regression
model.
• Next we will talk about how to conduct joint
hypothesis tests.
• Joint hypothesis tests impose restrictions on several
elements of the coefficient vector at the same time.
(see Hayashi p.39-45).

19

Joint restrictions
• Often times we are interested in examining
hypotheses that impose restrictions on more than
one coefficient in the vector b.
• Consider for instance the following regression:

Yt = At K tθ N t( 1− θ )
or
l o g Y t = θ log K t + (1 − θ ) l o g N t + l o g At
• where,
° Yt= output, Kt= capital, Nt= labor, At= Technology
shock.
20

Joint Restrictions
• Question: How would we estimate the previous
equation using OLS?
logYt = β1 + β2 log Kt + β3 log Nt +εt
• But how do we impose the restriction that:
β 2 = θ
β 3 = (1 − θ )

21

7
 Joint Hypotheses
• We estimate the following restricted linear
regression:

logYt = β1 + β2 log Kt +(1− β2 )log Nt +ε t

or,
logYt − log Nt = β1 + β2 (log Kt − log Nt ) + εt

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Joint Hypotheses
• How would we test the following null hypothesis?
H 0 :
β 2 = θ
β 3 = (1 − θ )

• Answer: use a F-test. To implement the F-test we

need to also estimate a regression that does not
impose H0, the null hypothesis.

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Joint Hypotheses
• The unrestricted regression is given by:

log Yt = β 1 + β 2 log K t + β 3 log Nt + ε t

• Then the F-test is given by Hayashi (1.4.11):

( S S R R − S S RU ) / r
F =
(S S RU ) / ( N − K )
• SSRR = Sum of squared errors from restricted regression.
• SSR U=Sum or squared errors from unrestricted regression
• r=number of restrictions (in this case 1). 24

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 Joint Hypotheses
• Decision rule for the F-test
° 1) Calculate the F-ratio.
° 2) Choose a critical value e.g. 0.05
° 2) Go to the table of the F distribution and look up the
entry for r the number of restrictions (numerator degrees
of freedom) and N-K for the denominator degrees of
freedom. Find the critical value in the table.
° 3) If your F-ratio is larger than that critical value reject
the null hypothesis.

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Joint Hypotheses.
• Gauss also has a function that finds the p -value. It’s
syntax is:
CDFFC(F-ratio,r,N-K). To implement the F-test
using this function construct the p -value which is
given as:
p=1-CDFFC(F-ratio,r,N-K);
° Reject H0 if p<critical value.
° Fail to reject H0 if p ≥ critical value.
• A small p value or alternatively a large F-ratio is
evidence against the null.
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