Ch2 Slides Edited

Chapter 2
A brief overview of the

classical linear regression model
1
‘Introductory Econometrics for Finance’ © Chris Brooks 2008
Regression
• Regression is probably the single most important tool at the

econometrician’s disposal.
But what is regression analysis?
• It is concerned with describing and evaluating the relationship

between a given variable (usually called the dependent variable) and
one or more other variables (usually known as the independent
variable(s)).

Some Notation
• Denote the dependent variable by y and the independent variable(s) by x1, x2, ... , xk
where there are k independent variables.
• Some alternative names for the y and x variables:

y x
dependent variable independent variables
regressand regressors
effect variable causal variables
explained variable explanatory variable
• Note that there can be many x variables but we will limit ourselves to the case
where there is only one x variable to start with. In our set-up, there is only one y
variable.

Regression is different from Correlation
• If we say y and x are correlated, it means that we are treating y and x in

a completely symmetrical way.
• In regression, we treat the dependent variable (y) and the independent

variable(s) (x’s) very differently. The y variable is assumed to be
random or “stochastic” in some way, i.e. to have a probability
distribution. The x variables are, however, assumed to have fixed
(“non-stochastic”) values in repeated samples.

Simple Regression
• For simplicity, say k=1. This is the situation where y depends on only one x
variable.
• Examples of the kind of relationship that may be of interest include:

– How asset returns vary with their level of market risk
– Measuring the long-term relationship between stock prices and
dividends.
– Constructing an optimal hedge ratio

Simple Regression: An Example
• Suppose that we have the following data on the excess returns on a fund
manager’s portfolio (“fund XXX”) together with the excess returns on a
market index:
Year, t Excess return Excess return on market index
= rXXX,t – rft = rmt - rft
1 17.8 13.7
2 39.0 23.2
3 12.8 6.9
4 24.2 16.8
5 17.2 12.3
• We have some intuition that the beta on this fund is positive, and we
therefore want to find whether there appears to be a relationship between x
and y given the data that we have. The first stage would be to form a scatter
plot of the two variables.

Graph (Scatter Diagram)
45
40
Excess return on fund XXX
35
30
25
20
15
10
5
0
0 5 10 15 20 25
Excess return on market portfolio

Finding a Line of Best Fit
• We can use the general equation for a straight line,

y=a+bx
to get the line that best “fits” the data.
• However, this equation (y=a+bx) is completely deterministic.
• Is this realistic? No. So what we do is to add a random disturbance

term, u into the equation.
y t =  +  x t + ut
where t = 1,2,3,4,5

Why do we include a Disturbance term?
• The disturbance term can capture a number of features:
- We always leave out some determinants of yt

- There may be errors in the measurement of yt that cannot be
modelled.
- Random outside influences on yt which we cannot model

Determining the Regression Coefficients
• So how do we determine what  and  are?

• Choose  and  so that the (vertical) distances from the data points to the
fitted lines are minimised (so that the line fits the data as closely as
possible): y

Ordinary Least Squares
• The most common method used to fit a line to the data is known as
OLS (ordinary least squares).
• What we actually do is take each distance and square it (i.e. take the
area of each of the squares in the diagram) and minimise the total sum
of the squares (hence least squares).
• Tightening up the notation, let

yt denote the actual data point t
ŷt denote the fitted value from the regression line
ût denote the residual, yŷt- t

Actual and Fitted Value
yi
û i
ŷ i
xi x

How OLS Works
• So min. uˆ1  uˆ 2  uˆ3  uˆ 4  uˆ5 , or minimise

2 2 2 2 2
 uˆ
t 1
2
t . This is known
as the residual sum of squares.
• But what was ût ? It was the difference between the actual point and
the line, yt - ŷt .
• 
So minimising  t
y  ˆ
y t 2
is equivalent to minimising  t
ˆ
u 2
with respect to  and  .

What do We Use  and  For?
• In the CAPM example used above, plugging the 5 observations in to make up

the formulae given above would lead to the estimates
 = -1.74 and = 1.64. We would write the fitted line as:
yˆ t  1.74  1.64 x t
• Question: If an analyst tells you that she expects the market to yield a return
20% higher than the risk-free rate next year, what would you expect the return
on fund XXX to be?
• Solution: We can say that the expected value of y = “-1.74 + 1.64 * value of
x”, so plug x = 20 into the equation to get the expected value for y:
yˆ i  1.74  1.64 20  31.06

Accuracy of Intercept Estimate
• Care needs to be exercised when considering the intercept estimate, particularly

if there are no or few observations close to the y-axis:
y
0 x

The Population and the Sample
• The population is the total collection of all objects or people to be studied,

for example,
• Interested in Population of interest

predicting outcome the entire electorate
of an election
• A sample is a selection of just some items from the population.
• A random sample is a sample in which each individual item in the

population is equally likely to be drawn.

The DGP and the PRF
• The population regression function (PRF) is a description of the model

that is thought to be generating the actual data and the true relationship
between the variables (i.e. the true values of  and ).
• The PRF is yt    xt  ut
• The SRF is yˆ t  ˆ  ˆxt

and we also know that uˆt  yt  yˆ t .
• We use the SRF to infer likely values of the PRF.
• We also want to know how “good” our estimates of  and  are.

Linearity
• In order to use OLS, we need a model which is linear in the parameters ( 

and  ). It does not necessarily have to be linear in the variables (y and x).
• Linear in the parameters means that the parameters are not multiplied
together, divided, squared or cubed etc.
• Some models can be transformed to linear ones by a suitable substitution or

manipulation, e.g. the exponential regression model
Yt  e X t e ut ln Yt     ln X t  ut
• Then let yt=ln Yt and xt=ln Xt
yt    xt  ut

Linear and Non-linear Models
• This is known as the exponential regression model. Here, the coefficients

can be interpreted as elasticities.
• Similarly, if theory suggests that y and x should be inversely related:


yt     ut
xt
then the regression can be estimated using OLS by substituting
1
zt 
xt
• But some models are intrinsically non-linear, e.g.

yt    xt  ut

Estimator or Estimate?
• Estimators are the formulae used to calculate the coefficients
• Estimates are the actual numerical values for the coefficients.

The Assumptions Underlying the
Classical Linear Regression Model (CLRM)
• The model which we have used is known as the classical linear regression model.
• We observe data for xt, but since yt also depends on ut, we must be specific about how the
ut are generated.
• We usually make the following set of assumptions about the ut’s (the unobservable error
terms):
• Technical Notation Interpretation
1. E(ut) = 0 The errors have zero mean
2. Var (ut) = 2 The variance of the errors is constant and finite
over all values of xt
3. Cov (ui,uj)=0 The errors are statistically independent of
one another
4. Cov (ut,xt)=0 No relationship between the error and
corresponding x variate

The Assumptions Underlying the
CLRM Again
• An alternative assumption to 4., which is slightly stronger, is that the

xt’s are non-stochastic or fixed in repeated samples.
• A fifth assumption is required if we want to make inferences about the

population parameters (the actual  and ) from the sample

parameters( and )
• Additional Assumption
5. ut is normally distributed

Properties of the OLS Estimator
• If assumptions 1. through 4. hold, then the estimators  and  determined by

OLS are known as Best Linear Unbiased Estimators (BLUE).
What does the acronym stand for?
• “Estimator” - is an estimator of the true value of .


• “Linear”- is alinear estimator
• “Unbiased” - On average, the actual value ofthe and ’s will be
equal to the true values.
• “Best” - means that the OLS estimator has 
minimum variance among
the class of linear unbiased estimators. The Gauss-Markov
theorem proves that the OLS estimator is best.

Consistency/Unbiasedness/Efficiency
• Consistent
The least squares estimators and 
 are consistent. That is, the estimates will converge to
their true values as the sample size increases to infinity. Need the assumptions
E(xtut)=0 and Var(ut)=2 <  to prove this. Consistency implies that
• Unbiased T 

lim Pr ˆ      0    0
The least squares estimates of and are unbiased. That is E( )=  and E( )= 
   
Thus on average the estimated value will be equal to the true values. To prove this also
requires the assumption that E(ut)=0. Unbiasedness is a stronger condition than
consistency.
• Efficiency
An estimator of  parameter  is said to be efficient if it is unbiased and no other unbiased
estimator has a smaller variance. If the estimator is efficient, we are minimising the
probability that it is a long way off from the true value of .

Precision and Standard Errors
• Any set of regression estimates of  

and  specific to the sample used in their
are
estimation.
• Recall that the estimators of  and  from the sample parameters ( and ) aregiven
by
ˆ  xt yt  Tx y
 ˆ andˆ  y  x
2 2
 x  Tx
t
• What we need is some measure of the reliability or precision of the estimators
(  and  ). The precision of the estimate is given by its standard error. Given
assumptions 1 - 4 above, then the standard errors can be shown to be given by
 xt
2
SE (ˆ )  s
 t
x 2
s ,
T  ( xt  x ) 2
T  x T x
t
2 2 2
1 1
SE ( ˆ )  s s
 ( xt  x ) 2
where s is the estimated standard deviation of the residuals.  t
x 2
 T x 2

Estimating the Variance of the Disturbance Term
• The variance of the random variable ut is given by

Var(ut) = E[(ut)-E(ut)]2
which reduces to
Var(ut) = E(ut2)
• We could estimate this using the average of u 2:

t
1
s2 
T
 ut2
• Unfortunately this is not workable since

ût ut is not 1
observable. We can use
the sample counterpart to ut, which is : s 2

T
ˆ
u 2
t 
But this estimator is a biased estimator of 2.

Estimating the Variance of the Disturbance Term
(cont’d)
• An unbiased estimator of  is given by

s
 t
ˆ
u 2
T 2
where  uˆ 2
t is the residual sum of squares and T is the sample size.
Some Comments on the Standard Error Estimators

 ) depend on s2 (or s). The greater the variance s2,
1. Both SE( ) and SE(
then the more dispersed the errors are about their mean value and therefore
the more dispersed y will be about its mean value.
2. The sum of the squares of x about their mean appears in both formulae.
The larger the sum of squares, the smaller the coefficient variances.

Consider what happens if 

 tx  x 2
is small or large:
y
y
y
y
0 x x 0 x x

(cont’d)
3. The larger the sample size, T, the smaller will be the coefficient
variances. T appears explicitly in SE( ) and implicitly in SE( ).
T appears implicitly since the sum 

 tx  x 2
is from t = 1 to T.
4. The term  xt appears in the SE( ).

2
The reason is that  xt

2
measures how far the points are away from the
y-axis.

Example: How to Calculate the Parameters and
Standard Errors
• Assume we have the following data calculated from a regression of y on a
single variable x and a constant over 22 observations.
• Data:
 xt yt  830102, T  22, x  416.5, y  86.65,
 t  3919654, RSS  130.6
x 2
• Calculations:   830102  (22 * 416.5 * 86.65)  0.35

3919654  22 * (416.5) 2
  86.65  0.35 * 416.5  59.12

• We write yˆ t  ˆ  ˆxt
yˆ t  59.12  0.35 xt

Example (cont’d)
 uˆ t2 130.6
• SE(regression), s    2.55
T 2 20
3919654
SE ( )  2.55 *  3.35

22  3919654  22  416.5 2

1
SE (  )  2.55 *  0.0079

3919654  22  416.5 2

• We now write the results as
yˆ t   59.12  0.35 xt
(3.35) (0.0079)

An Introduction to Statistical Inference
• We want to make inferences about the likely population values from

the regression parameters.
Example: Suppose we have the following regression results:

yˆ t  20.3  0.5091xt
(14.38) (0.2561)
•   0.5091 is a single (point) estimate of the unknown population
parameter, . How “reliable” is this estimate?
• The reliability of the point estimate is measured by the coefficient’s

standard error.

Hypothesis Testing: Some Concepts
• We can use the information in the sample to make inferences about the
population.
• We will always have two hypotheses that go together, the null hypothesis
(denoted H0) and the alternative hypothesis (denoted H1).
• The null hypothesis is the statement or the statistical hypothesis that is actually
being tested. The alternative hypothesis represents the remaining outcomes of
interest.
• For example, suppose given the regression results above, we are interested in the
hypothesis that the true value of  is in fact 0.5. We would use the notation
H0 :  = 0.5
H1 :   0.5
This would be known as a two sided test.

One-Sided Hypothesis Tests
• Sometimes we may have some prior information that, for example, we

would expect  > 0.5 rather than  < 0.5. In this case, we would do a
one-sided test:
H0 :  = 0.5
H1 :  > 0.5
or we could have had
H0 :  = 0.5
H1 :  < 0.5
• There are two ways to conduct a hypothesis test: via the test of
significance approach or via the confidence interval approach.

The Probability Distribution of the
Least Squares Estimators
• We assume that ut  N(0,2)
• Since the least squares estimators are linear combinations of the random variables
i.e.
   wt yt
• The weighted sum of normal random variables is also normally distributed, so
 N(, Var())
 N(, Var())

• What if the errors are not normally distributed? Will the parameter estimates still
be normally distributed?
• Yes, if the other assumptions of the CLRM hold, and the sample size is
sufficiently large.

The Probability Distribution of the
Least Squares Estimators (cont’d)
• Standard normal variates can be constructed from  and  :
ˆ   ˆ  
~ N 0,1 and ~ N 0,1
var  var 
• But var() and var() are unknown, so
ˆ   ˆ  
~ tT  2 and ~ tT  2
SE (ˆ ) ˆ
SE (  )

Testing Hypotheses:
The Test of Significance Approach
• Assume the regression equation is given by ,

yt    xt  ut for t=1,2,...,T
• The steps involved in doing a test of significance are:

1. Estimate  ,  and SE( ) , SE(  ) in the usual way
2. Calculate the test statistic. This is given by the formula

   *
test statistic 
SE (  )
where  * is the value of  under the null hypothesis.

The Test of Significance Approach (cont’d)
3. We need some tabulated distribution with which to compare the estimated test
statistics. Test statistics derived in this way can be shown to follow a t-
distribution with T-2 degrees of freedom.
As the number of degrees of freedom increases, we need to be less cautious in
our approach since we can be more sure that our results are robust.
4. We need to choose a “significance level”, often denoted . This is also

sometimes called the size of the test and it determines the region where we will
reject or not reject the null hypothesis that we are testing. It is conventional to
use a significance level of 5%.
Intuitive explanation is that we would only expect a result as extreme as this or
more extreme 5% of the time as a consequence of chance alone.
Conventional to use a 5% size of test, but 10% and 1% are also commonly used.

Determining the Rejection Region for a Test of
Significance
5. Given a significance level, we can determine a rejection region and non-
rejection region. For a 2-sided test:
f(x)
2.5% 95% non-rejection 2.5%

rejection region region rejection region

The Rejection Region for a 1-Sided Test (Upper Tail)
f(x)
95% non-rejection
region 5% rejection region

The Rejection Region for a 1-Sided Test (Lower Tail)
f(x)
95% non-rejection region

5% rejection region

The Test of Significance Approach: Drawing
Conclusions
6. Use the t-tables to obtain a critical value or values with which to

compare the test statistic.
7. Finally perform the test. If the test statistic lies in the rejection
region then reject the null hypothesis (H0), else do not reject H0.

A Note on the t and the Normal Distribution
• You should all be familiar with the normal distribution and its
characteristic “bell” shape.
• We can scale a normal variate to have zero mean and unit variance by
subtracting its mean and dividing by its standard deviation.
• There is, however, a specific relationship between the t- and the

standard normal distribution. Both are symmetrical and centred on
zero. The t-distribution has another parameter, its degrees of freedom.
We will always know this (for the time being from the number of
observations -2).

What Does the t-Distribution Look Like?
normal distribution
t-distribution

Comparing the t and the Normal Distribution
• In the limit, a t-distribution with an infinite number of degrees of freedom is a

standard normal, i.e. t ()  N (0,1)
• Examples from statistical tables:

Significance levelN(0,1) t(40) t(4)
50% 0 0 0
5% 1.64 1.68 2.13
2.5% 1.96 2.02 2.78
0.5% 2.57 2.70 4.60
• The reason for using the t-distribution rather than the standard normal is that
we had to estimate  ,2the variance of the disturbances.

The Confidence Interval Approach
to Hypothesis Testing
• An example of its usage: We estimate a parameter, say to be 0.93, and

a “95% confidence interval” to be (0.77,1.09). This means that we are
95% confident that the interval containing the true (but unknown)
value of .
• Confidence intervals are almost invariably two-sided, although in

theory a one-sided interval can be constructed.

How to Carry out a Hypothesis Test
Using Confidence Intervals
1. Calculate  ,  and SE( ) , SE(  ) as before.
2. Choose a significance level, , (again the convention is 5%). This is equivalent to

choosing a (1-)100% confidence interval, i.e. 5% significance level = 95%
confidence interval
3. Use the t-tables to find the appropriate critical value, which will again have T-2
degrees of freedom.
4. The confidence interval is given by ( ˆ  t crit  SE ( ˆ ), ˆ  t crit  SE ( ˆ ))
5. Perform the test: If the hypothesised value of  (*) lies outside the confidence
interval, then reject the null hypothesis that  = *, otherwise do not reject the null.

Confidence Intervals Versus Tests of Significance
• Note that the Test of Significance and Confidence Interval approaches always give the
same answer.
• Under the test of significance approach, we would not reject H0 that  = * if the test
statistic lies within the non-rejection region, i.e. if
   *
t crit    t crit
SE (  )
• Rearranging, we would not reject if
 t crit  SE ( ˆ )  ˆ   *  t crit  SE ( ˆ )
• But this is just theˆrule
 under
t the ( ˆ )  interval
SEconfidence *  ˆapproach.
 t  SE ( ˆ )
crit crit

Constructing Tests of Significance and
Confidence Intervals: An Example
• Using the regression results above,
yˆ t  20.3  0.5091xt
, T=22
(14.38) (0.2561)
• Using both the test of significance and confidence interval approaches,
test the hypothesis that  =1 against a two-sided alternative.
• The first step is to obtain the critical value. We want tcrit = t20;5%

Determining the Rejection Region
f(x)
2.5% rejection region 2.5% rejection region
-2.086 +2.086

Performing the Test
• The hypotheses are:

H0 :  = 1
H1 :   1
Test of significance Confidence interval

approach approach
   * ˆ  t crit  SE ( ˆ )
test stat 
SE (  )
05091
. 1  0.5091  2.086  0.2561
  1917
.
0.2561  (0.0251,1.0433)
Do not reject H0 since Since 1 lies within the
test stat lies within confidence interval,
non-rejection region do not reject H0

Testing other Hypotheses
• What if we wanted to test H 0 :  = 0 or H0 :  = 2?
• Note that we can test these with the confidence interval approach.
For interest (!), test
H0 :  = 0
vs. H1 :   0
H0 :  = 2
vs. H1 :   2

Changing the Size of the Test
• But note that we looked at only a 5% size of test. In marginal cases

(e.g. H0 :  = 1), we may get a completely different answer if we use a
different size of test. This is where the test of significance approach is
better than a confidence interval.
• For example, say we wanted to use a 10% size of test. Using the test of
significance approach,    *
test stat 
SE (  )
05091
. 1
  1917
.
0.2561
as above. The only thing that changes is the critical t-value.

Changing the Size of the Test:
The New Rejection Regions
f(x)
5% rejection region 5% rejection region
-1.725 +1.725

Changing the Size of the Test:
The Conclusion
• t20;10% = 1.725. So now, as the test statistic lies in the rejection region,
we would reject H0.
• Caution should therefore be used when placing emphasis on or making

decisions in marginal cases (i.e. in cases where we only just reject or
not reject).

Some More Terminology
• If we reject the null hypothesis at the 5% level, we say that the result
of the test is statistically significant.
• Note that a statistically significant result may be of no practical

significance. E.g. if a shipment of cans of beans is expected to weigh
450g per tin, but the actual mean weight of some tins is 449g, the
result may be highly statistically significant but presumably nobody
would care about 1g of beans.

The Errors That We Can Make
Using Hypothesis Tests
• We usually reject H0 if the test statistic is statistically significant at a

chosen significance level.
• There are two possible errors we could make:

1. Rejecting H0 when it was really true. This is called a type I error.
2. Not rejecting H0 when it was in fact false. This is called a type II error.
Reality
H0 is true H0 is false
Significant Type I error 
Result of (reject H0) =
Test Insignificant Type II error
( do not  =
reject H0)

The Trade-off Between Type I and Type II Errors
• The probability of a type I error is just , the significance level or size of test we
chose. To see this, recall what we said significance at the 5% level meant: it is
only 5% likely that a result as or more extreme as this could have occurred purely
by chance.
• Note that there is no chance for a free lunch here! What happens if we reduce the
size of the test (e.g. from a 5% test to a 1% test)? We reduce the chances of
making a type I error ... but we also reduce the probability that we will reject the
null hypothesis at all, so we increase the probability of a type II error:
less likely
to falsely reject
Reduce size  more strict  reject null
of test criterion for hypothesis more likely to
rejection less often incorrectly not
reject
• So there is always a trade off between type I and type II errors when choosing a
significance level. The only way we can reduce the chances of both is to increase
the sample size.
A Special Type of Hypothesis Test: The t-ratio
• Recall that the formula for a test of significance approach to hypothesis

testing using a t-test was
i   i*
test statistic 
SE i 
• If the test is H0 : i = 0
H1 : i  0
i.e. a test that the population coefficient is zero against a two-sided
alternative, this is known as a t-ratio test:
Since  i* = 0, test stat  i

SE ( i )
• The ratio of the coefficient to its SE is known as the t-ratio or t-statistic.

The t-ratio: An Example
• Suppose that we have the following parameter estimates, standard errors and t-
ratios for an intercept and slope respectively.
Coefficient 1.10 -4.40
SE 1.35 0.96
t-ratio 0.81 -4.63
Compare this with a tcrit with 15-3 = 12 d.f.

(2½% in each tail for a 5% test) = 2.179 5%
= 3.055 1%
• Do we reject H0: 1 = 0? (No)
H0 : 2 = 0? (Yes)

What Does the t-ratio tell us?
• If we reject H0, we say that the result is significant. If the coefficient is not
“significant” (e.g. the intercept coefficient in the last regression above), then
it means that the variable is not helping to explain variations in y. Variables
that are not significant are usually removed from the regression model.
• In practice there are good statistical reasons for always having a constant
even if it is not y
significant. Look at what happens if no intercept is included:
t
x
t
An Example of the Use of a Simple t-test to Test a
Theory in Finance
• Testing for the presence and significance of abnormal returns (“Jensen’s

alpha” - Jensen, 1968).
• The Data: Annual Returns on the portfolios of 115 mutual funds from
1945-1964.
• The model:  j =j 
R jt  R ft for 1, 
…,j (115
Rmt  R ft )  u jt
• We are interested in the significance of j.
• The null hypothesis is H0 :  j = 0 .

Frequency Distribution of t-ratios of Mutual Fund
Alphas (gross of transactions costs)
Source Jensen (1968). Reprinted with the permission of Blackwell publishers.

Frequency Distribution of t-ratios of Mutual Fund
Alphas (net of transactions costs)
Source Jensen (1968). Reprinted with the permission of Blackwell publishers.

Conclusions
• Evidence of overreactions in stock returns.
• Losers tend to be small so we can attribute most of the overreaction in the

UK to the size effect.
Comments
• Small samples
• No diagnostic checks of model adequacy

The Exact Significance Level or p-value
• This is equivalent to choosing an infinite number of critical t-values from tables.

It gives us the marginal significance level where we would be indifferent
between rejecting and not rejecting the null hypothesis.
• If the test statistic is large in absolute value, the p-value will be small, and vice
versa. The p-value gives the plausibility of the null hypothesis.
e.g. a test statistic is distributed as a t62 = 1.47.

The p-value = 0.12.
• Do we reject at the 5% level?...........................No

• Do we reject at the 10% level?.........................No
• Do we reject at the 20% level?.........................Yes

Ch2 Slides Edited

Uploaded by

Copyright:

Available Formats

Ch2 Slides Edited

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Ch2 Slides Edited

Uploaded by

Copyright:

Available Formats

Chapter 2

A brief overview of the

• Regression is probably the single most important tool at the

But what is regression analysis?

• It is concerned with describing and evaluating the relationship

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• Some alternative names for the y and x variables:

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• If we say y and x are correlated, it means that we are treating y and x in

• In regression, we treat the dependent variable (y) and the independent

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• Examples of the kind of relationship that may be of interest include:

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• We can use the general equation for a straight line,

• However, this equation (y=a+bx) is completely deterministic.

• Is this realistic? No. So what we do is to add a random disturbance

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• The disturbance term can capture a number of features:

- We always leave out some determinants of yt

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• So how do we determine what  and  are?

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• Tightening up the notation, let

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• So min. uˆ1  uˆ 2  uˆ3  uˆ 4  uˆ5 , or minimise

with respect to  and  .

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• In the CAPM example used above, plugging the 5 observations in to make up

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• Care needs to be exercised when considering the intercept estimate, particularly

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• The population is the total collection of all objects or people to be studied,

• Interested in Population of interest

• A sample is a selection of just some items from the population.

• A random sample is a sample in which each individual item in the

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• The population regression function (PRF) is a description of the model

• The PRF is yt    xt  ut

• The SRF is yˆ t  ˆ  ˆxt

• We use the SRF to infer likely values of the PRF.

• We also want to know how “good” our estimates of  and  are.

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• In order to use OLS, we need a model which is linear in the parameters ( 

• Some models can be transformed to linear ones by a suitable substitution or

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• This is known as the exponential regression model. Here, the coefficients

• Similarly, if theory suggests that y and x should be inversely related:

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• Estimators are the formulae used to calculate the coefficients

• Estimates are the actual numerical values for the coefficients.

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• An alternative assumption to 4., which is slightly stronger, is that the

• A fifth assumption is required if we want to make inferences about the

‘Introductory Econometrics for Finance’ © Chris Brooks 2008

• If assumptions 1. through 4. hold, then the estimators  and  determined by