NORWEGIAN SCHOOL OF ECONOMICS

Examination Fall semester 2016

Code: FIE449 Course title: FINANCIAL ECONOMETRICS

Date: 16/12/2016 Time: 4 HOURS

The course instructor will not visit the examination room, but may be contacted by an examination
attendant by telephone, internal # +47 55 95 93 80."

Materials permitted for use during the examination

Dictionary: One dictionary is normally permitted.

Electronic calculator: NO: X

YES: ___
In accordance with the rules specified in "Utfyllende bestemmelser til Forskrift om eksamen
ved Norges Handelshøyskole (fulltidsstudiene)"

Other materials permitted:

Total pages including this one: 8

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This is a four hours exam, please read carefully the questions and justify your answers: one-
sentence answer is not enough! The maximum number of points for each question (out of 100)
is indicated in the brackets.
Question 1 (8 points)
Define the multiple linear regression model. What are the ordinary least squares (OLS)
assumptions for multiple linear regression? What are the properties of the OLS estimators
under these assumptions? For each assumption state the impact of its violation.
a. The conditional distribution of u given X has mean zero, that is, E(u|X = x) = 0.
b. (Xi,Yi), i =1,…,n, are i.i.d.
c. Large outliers in X and/or Y are rare.
d. No perfect multicollinearity
a)-c) are relevant for model with one regressor
a)-d) are relevant for the model with multiple regressors
under the four LS , the estimators are unbiased and convergent (consistent), and
approximately normally distributed.

Question 2 (23 points)

On his website, Kenneth French provides access to returns of different types of portfolios. One
of them is based on the past stock performance (momentum - returns computed during
month -12 to month -1). The loser portfolio is composed of stocks from the first decile (the
worst past returns) and the winner portfolio is composed of stocks from the last decile (the
largest past returns). We estimate the two following regressions for loser, winner, and the zero
cost portfolio (winner minus loser, wml):
𝑅𝑡 − 𝑅𝑓,𝑡 = 𝛼 + 𝛽 ∗ 𝑚𝑘𝑡𝑡 + 𝜀,𝑡 (A)

𝑅𝑡 − 𝑅𝑓,𝑡 = 𝛼 + 𝛽 ∗ 𝑚𝑘𝑡𝑡 + 𝑆 ∗ 𝑠𝑚𝑏𝑡 + 𝐻 ∗ ℎ𝑚𝑙𝑡 + 𝜀,𝑡 (B)

Where mkt is the excess return on the market, smb and hml are the Fama and French (1993)
size and book-to-market factors.
The results are reported in the following table (more than 50 years of monthly returns):

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 (1) (2) (3) (4) (5) (6)
looser winner wml looser winner wml

mkt 1.451 1.178 -0.272 1.379 1.044 -0.335

(0.000) (0.000) (0.002) (0.000) (0.000) (0.000)

smb 0.469 0.417 -0.0515

(0.000) (0.000) (0.719)

hml 0.0969 -0.330 -0.427

(0.394) (0.000) (0.011)

_cons -0.955 0.508 1.464 -1.090 0.582 1.672

(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)

N 606 606 606 606 606 606

R-square 0.650 0.718 0.031 0.679 0.778 0.057

p-values in parentheses

a. How do you interpret the coefficients and the intercepts of the regressions (A) and (B)?
The intercepts are the risk-adjusted performance, they represent the average excess
return above or below that predicted by the asset pricing model (here capm or 3 Factor
model). This metric is also commonly referred to as Jensen's alpha, or simply alpha.
The coefficients are the risk factor sensitivity of the asset. For a Long-short portfolio,
intercepts are the performance of the strategy that consists of buying an asset and
selling another, and the coefficients measure the difference of risk factor sensitivity of
these two assets.
b. Are the coefficients significant at the 1% level (p-values are in parentheses under each
coefficient estimate)? What could you conclude on the performance and the risk
profile of these portfolios?
1% level means p_value<0.01
All coefficients are significant except HML sensitivity in (4) and SMB one in (6).
Intercept of the regressions allow us to said that winner outperform and looser
underperform and the difference of performance is significant. The coefficients in (3)
and (6) demonstrate that winners have less systematic risk than loosers, seems to have
equal size (because they have a same SMB sensitivity) and have lower BTM ratio….
c. What columns should you read to measure the performance of the strategy that
consists of buying a portfolio of winners and selling a portfolio of losers? Discuss its
performance.
Columns (3) and (6)
The mean difference between monthly excess return of the winner portfolio and looser
is +1.464% with CAPM and it is significant at 1% level. It means that if we go long in

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 portfolio of winers and short in portfolio of loosers we can earn an excess return of
1.06%. For 3F model, the excess return is +1.672% and is also significant at 1% level…

Question 3 (23 points)

The following table is from Masulis et al. (2007)1. The table presents the estimation results of
three regressions (see column (1) to column (3)). Each regression uses a different measure of
antitakeover provisions2 in the acquiring company charter. These proxies are the GIM Index,
BCF Index and Staggered Board (higher index corresponds to more managerial power within
the firm). T-stats are reported in parentheses and letters indicate the level of significance as
mentioned in the caption of the table.
a. Briefly discuss and describe the event study methodology. What are the main steps
and the main assumptions of this methodology?
Price-based event studies originally designed to test the efficient market hypothesis
(EMH).
Aim is to examine the impact of events on the market value of specific companies,
considering that the market is efficient (valorization tool). Implicit assumptions of
event studies are: financial market are efficient and anticipation markets…
The main steps are: identification of the events, identification of the estimation and
event windows, estimation of the normal return generating process, computation of
the abnormal returns (ARi,t = Ri,t - E(Ri,t|Xt))….

b. What is the dependent variable in all of these three regressions (read the table
description)? What does it measure?
The dependent variable is the five-day cumulative abnormal returns of the bidder. In
an efficient market, abnormal returns around an announcement date measures the
wealth creation for shareholders (the NPV of the project)…

c. Discuss and interpret the coefficients of the different antitakeover measures. How are
the bidder’s antitakeover provisions related to the quality of the deal realized by the
company (as perceived by investor around the deal announcement)?
The coefficients are negative and highly significant (all at the 5% level, and one at the
1% level). If CAR measure the NPV of the deal, bidder with high level of antitakeover
provisions seems to create less value for their shareholders (agency problem).

d. In the case of regression specifications with interaction between binary and

continuous variables how do you interpret the coefficient attributed to this
interaction? In other words, how do you interpret the coefficient obtained for the
interaction term between High tech and Relative deal size?
The interaction term between binary (D) and continuous variable (X) allow the effect of
X to depend on D. Here the effect of the estimation of the relative deal size effect on

1
Masulis, R.W., Wang, C. and Xie, F., (2007). Corporate Governance and Acquirer Returns, Journal of Finance,
62 (4), pp. 1851 – 1889.
2
Antitakeover provisions are provisions taken by the management to deter or to make difficult unwanted
takeovers. In other words, it is more difficult to takeover a company with antitakeover provisions.

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 bidder CAR could be different for High tech and non High tech firms. Here the coefficient
of the “interaction term” is negative and significant (at the 1% level), so for high tech
firm the impact of relative size on bidder car is significantly lower compare to other
firm. To measure it, we need to add the coefficient of relative size (0.373 in column (1))
and the one obtained for the interaction term (-6.467 in column (1)). The unsignificancy
of the coefficient of relative size alone, and the result obtained in the previous
computation (-6.094) allow us to say that the level of relative size have an effect on
bidder car only for high-tech firms, and this effect is negative and significant.

e. The authors indicate that they add time (year) fixed effects in their regression. What
does that mean? Why is it important for their analysis?
One way is to add binary variables that identify the year of the observation and that
only for the T-1 year (to avoid perfect multicolinearity problem).
It allows to control for all omitted variable that vary over time but not across entity.

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Question 4 (23 points)
Betton et al. (2014)3 study the probability of success of M&A deals. The table VI of the paper
(see below) reports the results of a logit model estimation where the dependent variable is
equal to one when the contest is successful and zero otherwise. The main variables are: Target
Size, the logarithm of the target market value estimated 42 days before the announcement
date; NYSE/Amex, a dummy variable taking value 1 if the target is listed on the NYSE or the
Amex; Turnover, the average daily ratio of the target trading volume to total shares
outstanding over the 52 weeks before the announcement date; Poison Pill, a dummy variable
taking value 1 if the target has a poison pill; 52Weeks High, the ratio of the share price 42 days
before the announcement date to the maximum share price during the 52 weeks before the
announcement day minus 42; Toehold, a dummy variable taking value 1 if the bidder owns
shares of the target before the deal announcement; Listed Bidder, a dummy variable taking
value 1 if the bidder is a public company; Horizontal, a dummy variable taking value 1 if the
bidder and the target are in the same sector (share the same 4-digits primary SIC code);
Premium, the 8-weeks bid premium (price offered divided by the target stock price 8 weeks
before deal announcement); Tender Offer, a dummy variable taking value 1 if the transaction
is a tender offer; All Cash, a dummy variable taking value 1 if the payment is 100% cash;
Hostile, a dummy variable taking value 1 if target management responds negatively to the
acquisition proposal; Year 1990’s is a dummy variable taking value 1 if the deal is
announcement during the period 1990 to 1999.
a. When the dependent variable is binary, how do we interpret the predicted value of a
linear regression model (linear probability model)?
When Y is binary, the linear regression model: Yi = β0 + β1Xi + ui is called the linear
probability model because Pr(Y=1|X) = β0 + β1Xi. β1 = change in probability that Y = 1
for a unit change in X.
b. Why do the authors use a logit model instead of a linear probability model? (Think
about the major flaw of the linear probability models.)
Major flaw of OLS: it is not bounded between 0 and 1 and it is linear (so the effects of
unit change in X does nto depend on the level of X)
Logit regression models the probability of Y=1, given X, as the cumulative standard
logistic distribution function: Pr(Y = 1|X) = F(β0 + β1X) where F is the cumulative logistic
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distribution function: F(β0 + β1X) = 1+𝑒 −(𝛽0+𝛽1 𝑋) . β1 is the change in the log-odds for a
unit change in X. Does not have drawback of LPM.

c. What is the relation between the bid premium (Premium) and the probability of bid
success? Does it make sense? Is it significant at the 1% level (p-values are reported
under each coefficient estimate)?
The coefficient is positive and highly significant (at the 1% level because p-value under

3
Betton, S., Eckbo, B.E., Thompson, R. and Thorburn, K., (2014). Merger Negotiations with Stock Market
Feedback, Journal of Finance, 69 (4), pp. 1705 – 1745.

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 0.01). So it means that higher is the premium, higher is the probability that the deal
will be successful. It makes sense: higher is the price paid, higher is the probability that
the target shareholders will accept the deal !

d. Interpret and discuss the sign and the significance of the coefficients of the 52Weeks
High, Horizontal, and Hostile variables?
Be careful: the Horizontal and Hostile variables are dummies (binaries) variables so
normally the coefficient should be interpreted as a difference in group means, but here
the model is a logit so we cannot interpret directly the coefficient in term of impact on
probability.
So we can just interpret the sign as the direction of the impact of the variables on the
probability of success of the deal.
The horizontal coefficient is positive and it’s significant at the five level in two first
specifications (p-value<=0.05).
For 52WeeksHIgh, the coefficient is positive and significant at 1% level, that
demonstrates that the timing of acquisition in term of target stock price is important.

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Question 5 (23 points)
The following table and the text are from Giuli and Kostovetsky (2014).4 They examine the
effect of the political leanings of CEO’s and other firm’s stakeholder on its corporate social
responsibility (CSR) behavior. They used KLD score as dependent variable as a measure of the
level of firm social responsibility (higher KLD score means higher firm social responsibility).
The variables of interest, that measure the political affiliations, are: CEO D%, the CEO’s total
campaign contributions to democrats divided by her total contributions to both parties;
Independent directors D%, the average political affiliation of the board of directors (measure
like CEO D% but at the board of directors level); Non-CEO founders D%, the average political
affiliation of the firm’s founder(s) that is not current CEO (measure like CEO D%); and President
vote D%, the proportion of the vote received by the democratic candidate for president in the
last election in the state where the firm is headquartered. Political environment is a “score”
that mix the CEO D%, Non-CEO founders D% and President vote D% variables.
In Section 4 Endogeneity and alternative explanations, Giuli and Kosotvetsky (2014), the
authors write: “Before we conclude that our results in Section 3 indicate a causal relation
between a Democratic political environment and higher levels of CSR, we explore a number of
alternative explanations. One possible reason for our findings is that political contributions are
reflecting the party that corporate stakeholder believe is better for firm prospects, rather than
reflecting their personal beliefs. If more socially-responsible companies perform better when
Democrats are in power then we would have a reverse causality problem: companies with
higher KLD Scores would contribute more money to Democrats, creating the positive
correlation between Democratic contribution and CSR which we found in Section 3. (…).
Another potential explanation for our results is endogenous selection. Democrats might be
more likely to find employment at more socially responsible firms (perhaps because they
receive more personal utility from social responsibility or for others reasons. In addition, more
socially responsible firms might locate their headquarter in Democratic states and vice versa
for less socially-responsible firms…”

a) Discuss this text in the light of the course and propose a solution to tackle the potential
problems caused by endogeneity.
E(u|X)≠0 => endogeneity of regressor => biased coefficients. In order to address this
problem, we can use an instrument to isolate the exogenous variation of endogeneous
regressor and estimate 2SLS.

b) The authors answer is to find an instrumental variable: “In Panel A of table 7, we use two-
stage least squares (2SLS) regression and instrument our measures of political
environment. Our instrument is the political affiliation of the state in which the founder(s)
went to college…”. What are the properties of a good instrumental variable? What do the
authors assume when they make this choice for their instrument? What is 2SLS?

4
Giuli, A. and Kostovetsky, L., (2014). Are Red or Blue Companies More Likely to go Green? Politics and
Corporate Social Responsibility, Journal of Financial Economics, 111(1), pp. 158 –180.

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 Relevance (cov(X,Z) ≠0) can be tested by looking at the first stage F-stat (rule of thumb
F>10). H0: all the coefficients in front of the instruments are jointly equal to 0. We compare
the fit of the two models: one model includes instruments, another model does not include
instrument.
Exogeneity (cov(u,Z)=0) can be tested using J-test only if we have more instruments than
endogenous variables (equation is over-identified). H0: all the cov(u,Z1)= cov(u,Z2)=…=0
(jointly equal to 0). If J-test rejects than at least one (or all) of the instruments is
endogenous. J-test runs an IV estimation for each of the instruments and compare the
resulting coefficients. If all instrument are exogenous coefficients should be similar.
2SLS approach:
a. First-stage: regress X (endogeneous variable) on Z (instument) and all the
exogenous and control variables. Compute the predicted (fitted) value of the
first stage 𝑋̂.
b. Second-stage: regress Y on predicted values 𝑋̂ from the first-stage.
c. In order to get correct SE, both stages should be run in one go using 2sls
command. If you run the stages by hands than the SE of the second-stage will
not take into account that 𝑋̂ is also estimated.

c) Interpret in Panel A of the following table (Table 7-Panel A of the paper reports the results
of the second step of 2SLS where the instrument is the political affiliation of the state in
which the founder(s) went to college) the coefficient of the Predictor Variables (variables
of interest) and their significance (t-stats are in parentheses and stars indicate the level of
significance as mentioned in the caption of table).
Coefficients are positive and significant except for the specification (2). So the political
affiliations have a positive impact on the CSR behavior.

d) In Panel B of Table 7, the authors use firm fixed effects in their regression. Briefly discus
the advantage of using panel data. What is the fixed effects regression model? What type
of omitted variables firm fixed effects are dealing with? Name some of the factors that
might be picked up by firm fixed effects. Interpret the coefficient of the variables of
interest in Panel B and compare them to the coefficients of the variables of interest in
Panel A.
FE regressions allow us to control for omitted variables that not change over time but vary
across entities. Here general economic conditions are good candidates of this type of
factors. The coefficients on the variables of interest are all positive but only the
independent directors' political affiliation is statistically significant (at the 10% level). This
result could be explain by the very strong persistence in KLD scores overtime (so Firm FE
capture a large part of the variation of KLD score) so while the estimated relation is
positive, we are unable to reject the null hypothesis.

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