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Exam in Financial Econometrics

July 4, 2007 (90 min.) Prof. Paul Sderlind, PhD

Last name:

First name: .

Points:

/ 90

Grade:

Practical hints:
Please solve all 5 questions. You may answer the questions in English or German. This is an 'open book'-exam. You may use a calculator, the lecture notes and the relevant textbooks. There are (a maximum of) 90 points to be scored, i.e. the approximate time you should spend on 1 point is 1 minute.

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1)

Statistics and OLS Regression (30 points)

For two assets A and B, the following four demeaned (i.e. they now have a mean of zero) returns are given [in %]: Asset A: Ra1 = 2 Ra 2 = 1 4 Rat = 0 Ra 3 = 4 t =1 Ra 4 = 5 a) Asset B: Rb1 = 5 Rb 2 = 4 4 Rbt = 0 Rb 3 = 7 t =1 Rb 4 = 8

Calculate the correlation coefficient between asset A's return and asset B's return. [Notice: You can assume that these four data points comprise the population.] (12 points)

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b)

Suppose you have run an OLS-regression (without a constant!) of asset B's return on asset A's return. What do you know about the (fitted) residuals and their relationship to the regressor? (8 points)

The table below shows a regression output in Excel. These are the statistics obtained from an OLS-regression of asset B's (demeaned) return on asset A's (demeaned) return. The following questions are based on this regression output.
Regression Statistics Observations df Regression Residual Total 1 3 4

4 SS MS 146.173913 146.173913 7.826086957 2.60869565 154 F 56.03333333 Significance F 0.017382553 P-value 0.004938323 Upper 95% 2.54047794

X Variable 1

Coefficient Standard Error t Stat 1.782608696 0.238140242 7.48554162 Lower 95% 1.02473945

Consider the two-sided test of the null hypothesis H 0 : = 0 where a significance level (size) of 5% should be used.

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c)

Explain why you can (not) reject the null hypothesis. [Refer to the t-statistic, the p-value as well as to the confidence interval when answering this question.] (10 points)

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2)

CAPM (10 points)

Cov ( Ri , Rm ) e m Var ( Rm )

CAPM can be stated as follows

e ie = i m =

a)

Suppose you want to assess, based on CAPM, whether a specific mutual fund manager has outperformed a stock index such as the SMI. Which is the crucial assumption that you need to make? Explain. (5 points)

b)

Suppose you want to perform a t-test of the null hypothesis that i = 0 . What distribution does the corresponding test statistic have in large samples? Why? (5 points)

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3)
a)

Event Studies (10 points)

The market model seems to be the dominating model of normals returns. Explain its advantages compared to a simple constant mean return model. (4 points)

b)

Suppose that the cross-sectional average (of 27 assets) of the 3-day cumulative abnormal returns (car) is 0.5. The daily abnormal return of every asset has a standard deviation of 0.3. Test whether the cross-sectional average of the cumulative abnormal returns is significantly different from zero on a 5% significance level (two-sided test assuming normality). (6 points)

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4)
a)

Time Series Analysis and Predictability (20 points)

Consider the AR(1) model yt = ayt 1 + t where t is iid with an expected value of zero. Can you estimate this model by OLS? Explain. (4 points)

b)

Suppose you have an AR(2) of the form yt = 0.7 yt 1 + 0.2 yt 2 + t where t is a Gaussian white noise process with Var ( t ) = 0.5 . You know that y3 = 2 and y2 = 1 . What are the best forecasts of y4 and y5 ? (8 points)

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c)

Given the above AR(2): What is the 90%-confidence band for y5 ? (5 points)

d)

Is it possible that financial markets are efficient although asset returns can be predicted (to some extent) by simple methods such as autoregressions? Explain. (3 points)

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5)
a)

Time-Varying Volatility (20 points)

What are the differences between the heteroskedasticity concepts of White and Engle? Explain. Where are these concepts typically used in applied research or practice? Give one example for each of them. (8 points)

b)

Suppose you have to estimate an AR(1) for the returns of the SMI where the errors are assumed to have a GARCH(1,1) structure. Describe exactly how you would estimate such a model. (12 points)

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