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CFA Level II Item-set Solution
Study Session 3
June 2017
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Reading 9 Correlation and Regression FinQuiz.com
FinQuiz Level II 2017 Item-sets Solution
Reading 9: Correlation and Regression
1. Question ID: 11438

Correct Answer: B
Statement 1 is incorrect. A correlation coefficient of zero indicates that there is absolutely no
linear relation between the two variables. Variables with a correlation of 0 can have a strong
non-linear relationship. If there is no linear relationship, the value of one variable tells us
nothing about the value of the other variable.
Statement 2 is correct. Correlation coefficients can be computed validly if the means and
variances of the two variables, and the covariance between them, are finite and constant.
When these assumptions are not true, correlations between two different variables can depend
greatly on the sample that is used.

Correct Answer: B
Correlation that is induced by a calculation that mixes each of the two variables under
consideration with a third is termed as a spurious correlation, since it does not measure the
direct relationship between the variables. Spurious correlations can suggest results that may
not be true.

Correct Answer: A
Exhibit 1 shows that the correlation between large-cap and small-cap stocks is positive but
very low (0.13) which means the two indices represent distinct styles of investing. However,
the correlation of the micro-cap index with the large-cap index (and the small-cap index) is
very high (almost 1.0), which shows that there is very little difference between the two return
series, and therefore, we may not be able to justify distinguishing between large-cap value
and micro-cap value, or small-cap value and micro-cap value, as distinct investment styles.
Therefore, Option A is most appropriate as it also provides the most opportunity of
diversification.

Correct Answer: B
The t-statistic equals:
0.64210 2
= 2.368
1 (0.642)
Since the t-value is not less than 2.7854, the correlation coefficient is not statistically
significant (we cannot reject the null hypothesis).


Correct Answer: C
The slope coefficient equals:
0.000865
= = 1.248
0.000693
Since in a linear regression, the regression line fits through the point corresponding to the
means of the dependent and independent variables, solving for the intercept using this point,
we have:
= 0.1156 1.248(0.0785) = 0.0176

Correct Answer: A
! "#
=
"#" ! "#
0.2187
= = 0.6547
0.2187 + 0.1153
The F-statistic equals:

0.2187%
1 = 157.434
0.1153%
(85 2)

Correct Answer: C
Kitsis is incorrect with respect to Statement 1. If the correlation is positive one (perfect
positive correlation), all the points on the scatter plot lie on a straight line with a positive
slope. However, the slope depends on the relationship between the two variables; it could be
that when one variable increases by one unit the other increases by half a unit (with an
increase in one unit in one variable associated with exactly the same half-unit increase in the
other variable). The slope of the line can be different (but positive), but as long as the points
lie on a straight line the correlation between them will be 1.
Statement 2 is incorrect. Sample correlation can be an unreliable measure when outliers are
present. However, removing the outliers is not always the right thing to do, if the outliers
provide important information about the variables during the period under analysis. One must
use judgment to determine whether the outliers contain information about the variables
relationship (should be included in the analysis) or contain no information (and should be
excluded).

Correct Answer: A
Even though the correlation between NI and FCFF for the restaurant chain is much higher
than the correlation for the sports-wear manufacturer, however, only the correlation
coefficient for the sports-wear manufacturer is significant. This is most likely because the
sample size used for the analysis of the sports-wear manufacturer is much larger than the
sample size used for the restaurant chain. The larger the sample, the smaller the evidence in
terms of the magnitude of the sample correlation needed to reject the null hypothesis of zero
correlation. Recall that the t-statistic equals r(n-2)/1-r2. This shows that as n increases, the

t-statistic increases, so that even for a small value of r, the null hypothesis can be rejected. A
null hypothesis is more likely to be rejected as we increase the sample size, all else equal.

Correct Answer: C
Assumptions 1 and 4 are incorrect. The relationship between the dependent variable and the
independent variable should be linear in the parameters b0 and b1. This requirement does not
exclude the independent or dependent variable from being raised to a power other than one.
Assumption 4 is not an assumption of linear regression.

Correct Answer: A
If Tannis uses a lower level of significance, which is the same as using a higher level of
confidence, the critical t-value will increase. This choice leads to wider confidence intervals
and to a decreased likelihood of rejecting the null hypothesis. Decreasing the level of
significance from 0.05 to 0.01 decreases the probability of the Type 1 error, but it increases
the probability of the Type 2 error (failing to reject the null hypothesis when, in fact, it is
false).

Correct Answer: A
Bergren is correct. If the standard error is reduced to half of its current value, the confidence
interval will be half as large and the t-statistic twice as large (with a small standard error, the
t-value increases). When this happens, the probability of rejecting the null hypothesis
increases.

Correct Answer: A
If forecasts are unbiased, the value of b0 should be 0 and the value of b1 should be 1. At a
0.05 significance level, with 72-2 = 70 degrees of freedom, the critical t-value is 1.994. Given
the information in Exhibit 2, the 95% confidence interval for b0 is:
0.0239 1.994(0.4531)
0.8796 to 0.9274
The value of 0 falls within this interval so we cannot reject the null hypothesis that b0 = 0.
The 95% confidence interval for b1 is as follows:

0.9248 1.994(0.0948)
0.7358 to 1.1138
The value of 1 falls within this confidence interval, so we cannot reject the null hypothesis
that b1=1 at the 0.05 significance level. Because we cannot reject either of the null
hypotheses, we cannot reject the hypothesis that the forecasts are unbiased (which means they
are unbiased).


Correct Answer: A
The type of data used by the research team at West Newman for conducting their regression
analysis is cross-sectional data. This is because the analysts are comparing the effects of
earnings announcements on price changes across corporations.
If they had used earnings announcements for a single corporation and compared the effects of
announcements on that corporations share price change across time, the research team would
have been using time series data.
Factor models are not relevant here.

Correct Answer: A
The first assumption is consistent with the underlying assumptions. Linear regression
assumes that the relationship between the dependent variable and independent variable is
linear in the parameters, b0 and b1. This requires the latter two parameters to be raised to the
first power only. This requirement does not exclude, the independent variable (in this case E),
from being raised to a power other than 1.
The second assumption, outlined by the two senior analysts, is inconsistent with the
assumptions normally underlying linear regression. Linear regression assumes that the
expected value of the error term is 0 and not 1.
The third assumption is inconsistent with the underlying assumptions. Linear regression
assumes that the error term is normally distributed. Although linear regression may be
modified and still be used in the event error term is not normally distributed, the analysts
assumptions are inconsistent with the assumptions underlying linear regression.

Correct Answer: B
In order to determine the confidence interval, the following steps need to be followed:
1. Make the prediction:

Using the regression model, an EPS of $2.50 indicates change in per share value of
$39.056.
P1 P0 = 1.2458 + 15.1242($2.50) = $39.0563
2. Compute the variance of the prediction error:
The variance is calculated using the following formula:
s 2 2
1
= s 1 + +
(XX
2
)

n (n 1)s x
f 2
1 (2.50 1.6344 )
2
2
= 0.7542 1 + +
62 (62 1)0.4248
= 0.59444

The standard deviation of the forecast error is sf = (0.59444)0.5 = 0.7710
3. Determine the critical value of the t-statistic.

Given a 95% confidence interval and 62 2 = 60 degrees of freedom, the critical value of
the t-statistic, tc, 2.00.
4. Compute the value of the t-statistic.

The 95% confidence interval for P1 P0 extends from 39.0563 2.00(0.7710) to 39.0563
+ 2.00(0.7710), or 37.51430 to 40.59830.

Correct Answer: B
The hypothesized value of the slope coefficient does not fall within the confidence interval.
Therefore the null hypothesis that the slope coefficient is 3.50 is rejected. Since the null
hypothesis is rejected, this indicates the slope coefficient will not contribute in producing an
unbiased estimate of price change.
In order to test whether the regression model is able to produce unbiased forecasts, in terms
of the slope coefficient only, a confidence interval needs to be constructed for the slope
coefficient. Based on the hypothesized value of b1, 3.50, the confidence interval is
constructed as follows:
b1 t c sb
1
15.1242 2.00*(2.6556)
9.81300 to 20.43540
*The degrees of freedom are 62 2 = 60. Using a 95% confidence interval, the t-statistic is
2.00.

Correct Answer: A
The most appropriate response question 1 is a no and to question 2 is a Type I error.
The magnitude of r, the correlation coefficient, needed to reject the null hypothesis decreases
as sample size n decreases, for two reasons: 1) due to the degrees of freedom and the absolute
value of the critical tc value decreasing and 2) due to the absolute value of the numerator
increasing with larger n, resulting in larger magnitude t-values.
Selecting a 90% confidence interval, as opposed to 95%, will decrease the width of the
confidence interval and increase the likelihood of rejecting the null hypothesis when it is true,
i.e. increases the probability of a Type I error.
The tc value increases with higher levels of confidence. This will lead to a wider confidence
interval and a decreased likelihood of rejecting the null hypothesis. The converse can be said
to be true for lower levels of confidence, which will lead to narrower confidence intervals and
an increased chance of rejecting the null hypothesis.


Correct Answer: A
Limitation 1 fails to correspond with the limitations generally underlying linear regression. A
limitation of regression analysis is that public knowledge of the regression relationships may
negate their future usefulness. Public knowledge of stocks categorized as High, i.e. with
strong price reactions, may lead to analysts acting upon the relationship and bidding the price
of the stock up, rather than down. Thus stocks in this category may exhibit substantial price
increases. This may decrease the usefulness of the model to predict future price changes. The
standard estimate of the model may increase as the regression model produces inaccurate
forecasts of price changes.
Limitation 2 accurately captures a limitation of linear regression. Parameter instability can be

a particular problem when comparing the price changes of stocks across the three different
categories, in a cross-sectional context, as the characteristics of each category will certainly
differ.
Limitation 3 accurately captures a limitation of linear regression. If any of the regression

assumptions are violated, hypothesis tests and predictions based on linear regression will not
be valid.

Correct Answer: B
The regression model tries to explain the dependent variable through the use of the
independent variable.

Correct Answer: A
The coefficient of determination measures the fraction of the total variation in the dependent
variable that is caused by the independent variable.

Correct Answer: B
The critical value at 80% significance level with 10 degrees of freedom is 1.372.

Correct Answer: B
R2 = (Multiple R)2
= 0.40692 = 0.1656

Correct Answer: B
s2f = 0.002391[1+(1/12) + {(0.0518 0.0412)2 / (11 0.0846)}]
= 0.002391[1 + 0.0833 + (0.00011236/0.9306)]
= 0.002391[1 + 0.0833 + 0.00012074]
= 0.002391(1.08342)
= 0.0026


Correct Answer: C
Sf = 0.00261/2 = 0.0510
Predicted value of interest rate +/- tcsf = 0.02546 +/ (1.372 0.0510)

= 0.02546 +/ (0.0700)
= 0.0445 to 0.0954

Correct Answer: A
Regression residual is the difference between the actual and the predicted values of the
dependent variable.
Standard error of estimate measures the degree of variability between the actual and the
predicted values of the dependent variable.

Correct Answer: A
The covariance factor cannot tell the magnitude of the relation between two variables. It can
only point out the direction of the relationship.

Correct Answer: B
It is not possible to measure slope of a scatter graph with zero correlation as there is no linear
relation between the observations.

Correct Answer: A
The standard error of a correlation coefficient is used to determine the confidence intervals
around a true correlation of zero. If your correlation coefficient falls outside of this range,
then it is significantly different than zero.

Correct Answer: C
SSE = 0.00872 = 0.000076
SEE = [SSE/ (n-k-1)]1/2
= [0.000076/ 43]
= 0.001329

Correct Answer: A
SST = 0.00922 = 0.000085
RSS = SST SSE
= 0.000085 0.000076
= 0.000009


Correct Answer: C
Uncertainty in error term and uncertainty in the estimated parameters are the two sources of
uncertainty while carrying out regression analysis.

Correct Answer: A
Parameter instability states that the regression relations like correlations can change over
time. Regardless of whether the analyst is carrying out cross- section regression or time-series
regression, collecting samples from more than one population would increase parameter
instability.

Correct Answer: A
ANOVA is the procedure through which total variability is divided into components that are
matched to their respective sources. This analysis of variance is carried out through the F-test,
which is used to test whether all the slope coefficients are equal to zero.

Correct Answer: A
Confidence Range = B1+/ tc (sb1)
= 0.8 +/ 1.734 (0.48)
= 0.03 to 1.63

Correct Answer: B
Since the null hypothesis lies within the critical range, Brick would fail to reject the null
hypothesis.

Correct Answer: A
t = (B1 b1)/sb1
= (0.8 1.2)/ 0.48
= 0.833

Correct Answer: B
Acceptance of the null hypothesis is a binary decision. It will lead to an imminent rejection of
the alternative hypothesis.

Correct Answer: A
We cannot assume the independent variable is caused by the dependent variable, simply
because of the existence of correlation. A third variable could be the reason for the change in
both of the previous variables.


Correct Answer: A
Outliers are small numbers of observations at either extreme of a sample. Analysts need to
use judgment to determine whether the outliers contain information pertaining to the
relationship between the two variables or not.

Correct Answer: B
A Type II error = failure to reject the null hypothesis although it is wrong.
A decrease in the sample size will lead to an increase in the magnitude of the correlation
coefficient needed to reject the null hypothesis. This will also lead to an increase in the
critical value of the t-statistic, because of which the t-statistic will most likely fall within the
critical range.

Correct Answer: C
R2 = (Total Variation Unexplained Variation)/Total Variation
R2 = (0.004348 0.000532)/ 0.004348 = 0.877645

Correct Answer: C
SEE = [SSE/ (n k 1)]1/2
SEE = [0.000532/ (40 1 1)]
SEE = 0.003742 = 0.37%
or use
SEE = MSE1/2
SEE = 0.0000141/2
SEE = 0.003742

Correct Answer: A
Since the data uses many observations from across time periods for the same company, it can
be classified as time-series data.
The expected value of the error term is assumed to be zero in the linear regression model.

Correct Answer: B
t = r (n-2)/ (1-r2)
t = 0.154 123/ (1-0.1542) = 1.708/0.988 = 1.729
The calculated t-statistic is 1.729. Since this value falls outside the critical range, Cooper can
reject the null hypothesis and conclude that the relation between Revco and the automotive
index is statistically significant.


Correct Answer: C
SEE = MSE = 0.0064 = 0.08

Correct Answer: B
The calculated t-statistics for the intercept and the slope coefficients are
9.269 and 3.576 respectively. Since both these value fall outside the critical range, Cooper
can reject the null hypothesis and conclude that the relation between Revco and the
automotive index is statistically significant.
Intercept t-statistic = 0.0482/0.0052 = 9.269

Slope Coefficient t-statistic = 0.5893/ 0.1648 = 3.576

Correct Answer: B
Individual independent variables and their respective residuals are assumed to be
uncorrelated.

Correct Answer: A
Linear regression is also known as linear least squares since the selected values of the
intercept and the slope coefficient minimize the sum of squared vertical distances between the
observations and the regression line.

Correct Answer: A
The error of regression coefficient is the standard error of the slope.

Correct Answer: A
A higher level of significance will lead to a narrower confidence interval. In this case,
probability of rejecting the null hypothesis increases. Thus, the probability of Type I error
increases.

Correct Answer: A
A lower level of significance results in a higher critical value of the
t-statistic. This would decrease the probability of rejecting the null hypothesis. Thus, the
probability of Type I error would decrease.

Correct Answer: C
The p-value is the smallest level of significance at which the null hypothesis can be rejected.
When p<significance level, H0 can be rejected. If p>significance level, H0 cannot be rejected.


Correct Answer: B
The sum of squared regression residuals is the accumulated square of the difference between
the actual values of the dependent variable and the predicted value of the dependent variable.
The estimated parameters help in reducing this difference.

Correct Answer: B
Mean Square Error = Sum of Squared Errors/(n-2)
MSE = 125000/ (76) = 1645

Correct Answer: A
The correlation coefficient measures both the direction and the magnitude of a linear
relationship.

Correct Answer: A
The significance level of the correlation coefficient needs to be tested regardless of its value.
The t-test used to check the significance of the coefficient requires the number of
observations recorded.

Correct Answer: C
Correlation = Covariance/ (Std Devx Std Devy)
= 79.37/ {(50)1/2 (350)1/2}
= 0.600

Correct Answer: A
t = r (n 2)1/2/ (1 r2)1/2 = 0.6 (43)/ (1 0.36)
= 3.934/0.8 = 4.918

Correct Answer: A
The critical value of the t-statistic is 1.302 with 43 degrees of freedom and a p-value of 0.10.
Since the t-statistic falls out of the critical rang, Crater can reject the null hypothesis.

Correct Answer: C
Option C indicates a reliable correlation between two variables. However, Option A is
spurious as the two variables indicated can only have a viable correlation through dividing
them by another variable i.e. the number of shares. Option B is also spurious, as many other
factors affect a managers performance other than their gender.

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Reading 9 Correlation and Regression FinQuiz.

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FinQuiz Level II 2017 Item-sets Solution

Reading 9: Correlation and Regression

1. Question ID: 11438

2. Question ID: 11439

3. Question ID: 11440

4. Question ID: 11441

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5. Question ID: 11442

6. Question ID: 11443

The F-statistic equals:

7. Question ID: 15545

8. Question ID: 15546

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9. Question ID: 15547

10. Question ID: 15548

11. Question ID: 15549

12. Question ID: 15550

The 95% confidence interval for b1 is as follows:

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13. Question ID: 15580

Factor models are not relevant here.

14. Question ID: 15581

15. Question ID: 15582

1. Make the prediction:

2. Compute the variance of the prediction error:

The variance is calculated using the following formula:

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The standard deviation of the forecast error is sf = (0.59444)0.5 = 0.7710

3. Determine the critical value of the t-statistic.

4. Compute the value of the t-statistic.

16. Question ID: 15583

17. Question ID: 15584

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18. Question ID: 15585

Limitation 2 accurately captures a limitation of linear regression. Parameter instability can be

Limitation 3 accurately captures a limitation of linear regression. If any of the regression

19. Question ID: 18459

20. Question ID: 18460

21. Question ID: 18461

22. Question ID: 18462

23. Question ID: 18463

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24. Question ID: 18464

Predicted value of interest rate +/- tcsf = 0.02546 +/ (1.372 0.0510)

25. Question ID: 18466

26. Question ID: 18467

27. Question ID: 18468

28. Question ID: 18469

29. Question ID: 18470

30. Question ID: 18471

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31. Question ID: 18474

32. Question ID: 18475

33. Question ID: 18476

34. Question ID: 18477

35. Question ID: 18478

36. Question ID: 18479

37. Question ID: 18481

38. Question ID: 18482

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