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Advanced Econometrics- Assignment 2

Problem # 1:
a. Used Excel Addins function Analysis ToolPak > Data Analysis > Regression to do the

estimation.
This is a multiple linear regression with a) S&P 500 returns and the industry returns as
independent variables b) stock returns is the dependent variable
The linear regression model would be as follows:

yt : stock returns

yt 1 2 x2t 3 x3t t , t 1, 2,..T

x2t : S & P 500 returns


x3t : Industry returns

Following is the Summary Output:


Regression Statistics
0.928733544
Multiple R
0.862545997
R Square
0.85511605
Adjusted R Square
0.121703412
Standard Error
Observations

40

ANOVA
df
Regression
Residual
Total

Intercept
S&P Return
Industry Return

2
37
39

SS
3.438999416
0.548033658
3.987033074

Coefficients Standard Error

0.021423527
0.021616345
3.006318797
1.856435223

1.293186386
1.863567292

MS
F
1.719499708 116.0904778
0.01481172

t Stat

P-value

0.991079976 0.328083957
1.619404092 0.113853999

0.693930609 0.492059792

Significance F
1.1374E16

Lower 95%

Upper 95%

0.065222403
0.75517626

0.022375349
6.767813853

5.069132386

2.482759615

Using the summary output above, we write:


. . .
(0.0216) (1.8564)
(1.8636)
We note the following from the results:
Stock returns have a positive relationship with S&P500 returns, coefficient being 3.0063.
The coefficient of 3.0063 means that when S&P returns increases by 1 percent, stock return
will increase by 3.0063 percent.
Similarly, we observe that stock returns negative relationship with industry returns,
coefficient being 1.2932. The coefficient of 1.2932 means that when S&P returns increases
by 1 percent, stock return will decrease by 1.2932 percent.
In order to check the significance of the coefficients, tratios can be used to test if each coefficient is
zero against a twosided alternative. So, we do hypothesis testing for each coefficient at a 95%
confidence level. The critical value is then obtained from a tdistribution table for a twosided test using
a significance level of .05 and 37 df (degrees of freedom). (37 because there are 40 samples with 3
estimated coefficients. Therefore, 403 = 37). The critical value is 2.026. Reject the null hypothesis if the
tratio is outside the region (2.026, 2.026). The results are shown below:
Coefficient

0
1
2

Variable
Intercept
S&P 500
Returns
Industry
Returns

)
SE(

Tratio

Results

H1 : 0 0

0.0214

0.0216

0.991

Dont Reject

H 0 : 1 0

H1 : 1 0

3.0063

1.8564

1.619

Dont Reject

H 0 : 2 0

H1 : 2 0

1.2932

1.8636

0.694

Dont Reject

Null

Alternate

H 0 : 0 0

R^2 equals 0.8625, which means that our model using S&P return and industry return as the
two variables can explain 86.25% of the change of stock return. The rest 13.75% will be
explained by other factors contained in the residual term.

Fstatistic equals 1.7195/ 0.0148= 116.0905


From the F table, F(2,37) when =0.05 equals 3.2519. Since Fstatistic is greater than the
critical value, we reject the null hypothesis.

We can observe is there is supposed to be a positive relationship between stock returns and
S&P, and stock return and industry. However, the results showed the relationship between
stock return and industry to be negative. It could be because the two variables S&P returns
and industry have high correlation
Finally, we can say that there is a strong evidence of presence of multicollinearity because of

a) high value of R (very close to 1) b) high coefficient standard errors c) low tstat values
b) Summary Output for regression:
Regression Statistics

Multiple R
R Square
Adjusted R Square
Standard Error
Observations

0.998144831
0.996293104
0.996195554
0.010594144
40

ANOVA
Regression
Residual
Total

df
1
38
39

SS
MS
F
1.146283555 1.1462836 10213.164
0.004264964 0.0001122
1.150548519

Significance F
8.33979E48

Intercept
S&P Return

Coefficients
0.001748561
0.994324825

Standard Error
t Stat
Pvalue
0.001860176 0.9399979 0.3531558
0.009838936 101.0602
8.34E48

Lower 95%
0.002017168
0.974406941

From the results above, we conclude that the regression model is:

where x

0.001749 0.994324
(0.0019)
(0.0098)
S&P 500 returns and x Est. industry residual returns

We now test for the existence of multicollinearity as follows:

We calculate the Variance Inflation Factor (VIF) for the S&P 500 returns coefficient:

The value calculated is 270.2703. We know that if the VIF is greater than 10, especially
greater than 100, the multicolinearity is very severe. This means, our two explanatory
variables for the previous model are very highly correlated with each other
c. Using the Residual Output from the previous regression, we can see the residuals below:
Observation
1
2
3
4
5
6

Predicted Y
0.147095172
0.185443165
0.241892575
0.334743231
0.07299174
0.128050103

Residuals
0.001246474
0.009831554
0.010819001
0.003659931
0.016111605
0.002058562

Upper 95%
0.00551429
1.01424271

7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40

0.105973634
0.113337116
0.19989625
0.115626625
0.230621283
0.154032544
0.032821212
0.213824835
0.270626984
0.050881108
0.140279246
0.191868764
0.040601715
0.278487896
0.047512165
0.088014916
0.014522553
0.320552289
0.24740871
0.25757743
0.29633236
0.142540313
0.060997012
0.143734063
0.211355303
0.26444815
0.044672784
0.083657206
0.114833153
0.029948964
0.368343125
0.298123021
0.132979474
0.106084068

0.007820651
0.003262435
0.003691056
0.014670343
0.000158338
0.015014626
0.004198292
0.000772743
0.009437844
0.007597783
0.002026339
0.019505077
0.01511179
0.002256866
0.010003142
0.002821106
0.000156001
0.001174978
0.001446474
0.005110541
0.022714849
0.012553393
0.011168861
0.018855007
0.020034081
0.016173478
0.003012539
0.007781895
0.00763726
0.008757749
0.006879428
0.001907871
0.014286527
0.007015343

We now run the regression of:

Now substitute the residuals above as the second explanatory variables. And run the
regression of Stock Returns against those of the S&P500 and the industry.

Summary Output is as follows:


Regression Statistics
Multiple R
0.928733544
R Square
0.862545997
Adjusted R Square
0.85511605
Standard Error
0.121703412
Observations
40
ANOVA
Regression
Residual
Total

df
2
37
39

SS
3.438999416
0.548033658
3.987033074

MS
1.71949971
0.01481172

F
116.0905

Significance F
1.137E16

Intercept
S&P Return
Residuals

Coefficients
0.023684743
1.720471469
1.293186386

Standard Error
0.021369327
0.11302773
1.863567292

t Stat
1.1083523
15.2216759
0.6939306

Pvalue
0.274863
1.64E17
0.49206

Lower 95%
0.066983
1.4914555
5.069132

From the summary output, we the linear model is:


0.02368 1.7205 1.2931 ,
(0.0214)
(0.1130)
(1.864)
Note the following:
1.7205 means when S&P return increases by 1 percent, stock return will increase by 1.7205
percent. Similarly, 1.2932 means if the residual increases by 1 percent, the stock return will
decrease by 1.2932 percent.
R^2 equals 0.8625, it means our model using S&P return and residuals as the two variables
can explain 86.25% of the change of stock return. The rest 13.75% will be explained by other
factors contained in the new residual value
Fstatistic equals 1.7195/ 0.0148= 116.0905
Check the F table, F(2,37) when =0.05 equals 3.2519. Since Fstatistic is greater than the
critical value, we reject the null hypothesis

d) Summary Output is as follows:


Regression Statistics
Multiple R
0.927769955
R Square
0.86075709
Adjusted R
Square
0.857092802
Standard Error
0.120870319
Observations
40

Upper 95%
0.0196136
1.9494874
2.4827596

ANOVA
df
Regression
Residual
Total

1
38
39

SS
3.431866985
0.555166089
3.987033074

Intercept

Coefficients Standard Error

0.023684743
0.021223049

S&P 500

1.720471469

0.112254024

MS
3.431866985
0.014609634

t Stat
1.115991539
15.32659059

Significance
F
F
234.904379 7.4422E18

Pvalue

Lower 95%
Upper 95%

0.06664856 0.019279073

0.2714333
7.44218E
18 1.49322508

1.947717861

From the summary, we conclude the linear model to be:

. .
(0.0212) (0.112)
Note the following:

Stock returns have a positive relationship with 1.7205 times S&P500 returns
1.7205 means when S&P return increases by 1 percent, stock return will increase by 1.7205
percent.
R^2 equals 0.8608, it means our model using S&P return as the variable can explain 86.08%
of the change of stock return. The rest 13.92% will be explained by other factors contained
in residual.
Fstatistic equals 3.4319/0.0146=234.9044, which is greater than the critical value F(2,37),
so we would reject the null hypothesis
If we compare the results of this regression with part c), we find out the intercept and the
slope coefficient for the S&P Return, are the same for both models. R^2 is smaller and F
statistics is greater. This means:
The linear regression models are the same with the exception of the residual
orthogonalized component.
The residual component provides little to no additional value in explaining the variation of
stock returns and can be disregarded. We can conclude that S&P 500 returns are significant
and it can describe most of the variation in stock returns.