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# Introductory Econometrics for Finance Chris Brooks 2002 1

Chapter 3
A brief overview of the
classical linear regression model
Introductory Econometrics for Finance Chris Brooks 2002 2

Regression

Regression is probably the single most important tool at the
econometricians 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)).
Introductory Econometrics for Finance Chris Brooks 2002 3

Some Notation

Denote the dependent variable by y and the independent variable(s) by x
1
, x
2
,
... , x
k
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.

Introductory Econometrics for Finance Chris Brooks 2002 4

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) (xs) 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.

Introductory Econometrics for Finance Chris Brooks 2002 5

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

Introductory Econometrics for Finance Chris Brooks 2002 6
Simple Regression: An Example
Suppose that we have the following data on the excess returns on a fund
managers portfolio (fund XXX) together with the excess returns on a
market index:

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.
Year, t Excess return
= r
XXX,t
rf
t
Excess return on market index
= rm
t
- rf
t
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
Introductory Econometrics for Finance Chris Brooks 2002 7
Graph (Scatter Diagram)
0
5
10
15
20
25
30
35
40
45
0 5 10 15 20 25
Excess return on market portfolio
E
x
c
e
s
s

r
e
t
u
r
n

o
n

f
u
n
d

X
X
X
Introductory Econometrics for Finance Chris Brooks 2002 8
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
= o + |x
t
+ u
t

where t = 1,2,3,4,5

Introductory Econometrics for Finance Chris Brooks 2002 9
Why do we include a Disturbance term?
The disturbance term can capture a number of features:

- We always leave out some determinants of y
t

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

Introductory Econometrics for Finance Chris Brooks 2002 10
Determining the Regression Coefficients
So how do we determine what o and | are?
Choose o 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
x
Introductory Econometrics for Finance Chris Brooks 2002 11
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
y
t
denote the actual data point t
denote the fitted value from the regression line
denote the residual, y
t
-

t
y
t
y
t
u
Introductory Econometrics for Finance Chris Brooks 2002 12
Actual and Fitted Value

y

i
x x

i
y
i
y

i
u
Introductory Econometrics for Finance Chris Brooks 2002 13
How OLS Works
So min. , or minimise . This is known
as the residual sum of squares.

But what was ? It was the difference between the actual point and
the line, y
t
- .

So minimising is equivalent to minimising
with respect to and .

\$
o
\$
|
2
5
2
4
2
3
2
2
2
1
u u u u u + + + +
t
y
t
u

=
5
1
2

t
t
u
( )
2

t t
y y

2

t
u
Introductory Econometrics for Finance Chris Brooks 2002 14
Deriving the OLS Estimator
But , so let

Want to minimise L with respect to (w.r.t.) and , so differentiate L
w.r.t. and
(1)

(2)

From (1),

But and .
\$
o
\$
|
\$
o
\$
|
t t
x y | o

+ =

= =
t
t t
x y
L
0 )

( 2

| o
o c
c

= =
t
t t t
x y x
L
0 )

( 2

| o
| c
c
0

0 )

( = =

t t
t
t t
x T y x y | o | o

= y T y
t

= x T x
t

= =
t i
t t t t
x y y y L
2 2
)

( ) ( | o
Introductory Econometrics for Finance Chris Brooks 2002 15
Deriving the OLS Estimator (contd)
So we can write or (3)
From (2), (4)

From (3), (5)
Substitute into (4) for from (5),

\$
o
0

= x y | o

=
t
t t t
x y x 0 )

( | o
x y | o

= +
= +
= +
t
t t t
t
t t t t t
t
t t t
x x T x y T y x
x x x x y y x
x x y y x
0

0

0 )

(
2
2
2
| |
| |
| |
0

= x T T y T | o
Introductory Econometrics for Finance Chris Brooks 2002 16
Deriving the OLS Estimator (contd)
Rearranging for ,

So overall we have

This method of finding the optimum is known as ordinary least squares.

\$
|

=
t t t
y x x y T x x T ) (

2 2
|
x y
x T x
y x T y x
t
t t
| o |

and

2 2
=

## Introductory Econometrics for Finance Chris Brooks 2002 17

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:

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:
\$
o
\$
|
\$
o
\$
|
06 . 31 20 64 . 1 74 . 1 = + =
i
y
t t
x y 64 . 1 74 . 1

+ =
Introductory Econometrics for Finance Chris Brooks 2002 18
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
Introductory Econometrics for Finance Chris Brooks 2002 19

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.

Introductory Econometrics for Finance Chris Brooks 2002 20

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 o and |).

The PRF is

The SRF is
and we also know that .

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

We also want to know how good our estimates of o and | are.

t t
x y | o

+ =
t t t
u x y + + = | o
t t t
y y u =
Introductory Econometrics for Finance Chris Brooks 2002 21
Linearity

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

Then let y
t
=ln Y
t
and x
t
=ln X
t

t t t
u x y + + = | o
t t t
u
t t
u X Y e X e Y
t
+ + = = ln ln | o
| o
Introductory Econometrics for Finance Chris Brooks 2002 22
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:

then the regression can be estimated using OLS by substituting

But some models are intrinsically non-linear, e.g.

t
t
t
u
x
y + + =
|
o
t
t
x
z
1
=
t t t
u x y + + =
|
o
Introductory Econometrics for Finance Chris Brooks 2002 23
Estimator or Estimate?

Estimators are the formulae used to calculate the coefficients

Estimates are the actual numerical values for the coefficients.

Introductory Econometrics for Finance Chris Brooks 2002 24
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 x
t
, but since y
t
also depends on u
t
, we must be specific about
how the u
t
are generated.
We usually make the following set of assumptions about the u
t
s (the
unobservable error terms):
Technical Notation Interpretation
1. E(u
t
) = 0 The errors have zero mean
2. Var (u
t
) = o
2
The variance of the errors is constant and finite
over all values of x
t

3. Cov (u
i
,u
j
)=0 The errors are statistically independent of
one another
4. Cov (u
t
,x
t
)=0 No relationship between the error and
corresponding x variate
Introductory Econometrics for Finance Chris Brooks 2002 25
The Assumptions Underlying the
CLRM Again
An alternative assumption to 4., which is slightly stronger, is that the
x
t
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 o and |) from the sample parameters
( and )

5. u
t
is normally distributed

\$
o
\$
|
Introductory Econometrics for Finance Chris Brooks 2002 26

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.
\$
o
\$
|
\$
|
\$
|
\$
|
\$
|
\$
o
Introductory Econometrics for Finance Chris Brooks 2002 27
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(x
t
u
t
)=0 and Var(u
t
)=o
2
< to prove this. Consistency implies that

Unbiased
The least squares estimates of and are unbiased. That is E( )=o and E( )=|
Thus on average the estimated value will be equal to the true values. To prove
this also requires the assumption that E(u
t
)=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 |.
\$
|
\$
|
\$
o
\$
o
\$
o
\$
|
\$
|
| | 0 0

## Pr lim > = >

o o | |
T
Introductory Econometrics for Finance Chris Brooks 2002 28

Precision and Standard Errors

Any set of regression estimates of and are specific to the sample used in
their estimation.
Recall that the estimators of o and | from the sample parameters ( and ) are
given by

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

where s is the estimated standard deviation of the residuals.
\$
o
\$
|
\$
|
\$
|
\$ o
\$
o
x y
x T x
y x T y x
t
t t
| o |

and

2 2
=

=
2 2 2
2 2 2
2
2
2
1
) (
1
)

(
,
) (
) (
x T x
s
x x
s SE
x T x T
x
s
x x T
x
s SE
t t
t
t
t
t
|
o
Introductory Econometrics for Finance Chris Brooks 2002 29
Estimating the Variance of the Disturbance Term
The variance of the random variable u
t
is given by
Var(u
t
) = E[(u
t
)-E(u
t
)]
2

which reduces to
Var(u
t
) = E(u
t
2
)

We could estimate this using the average of :

Unfortunately this is not workable since u
t
is not observable. We can use
the sample counterpart to u
t
, which is :

But this estimator is a biased estimator of o
2
.

2
t
u

=
2 2
1
t
u
T
s

=
2 2

1
t
u
T
s
t
u
Introductory Econometrics for Finance Chris Brooks 2002 30
Estimating the Variance of the Disturbance Term
(contd)
An unbiased estimator of o is given by

where is the residual sum of squares and T is the sample size.

Some Comments on the Standard Error Estimators
1. Both SE( ) and SE( ) depend on s
2
(or s). The greater the variance s
2
, 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.
\$
o
\$
|
2

=

T
u
s
t

t
u
Introductory Econometrics for Finance Chris Brooks 2002 31
Some Comments on the Standard Error Estimators

Consider what happens if is small or large:

y

y
0
x
x
y

y
0
x
x
( )
2

x x
t
Introductory Econometrics for Finance Chris Brooks 2002 32
Some Comments on the Standard Error Estimators
(contd)
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 is from t = 1 to T.

4. The term appears in the SE( ).
The reason is that measures how far the points are away from the
y-axis.

\$
o
\$
|
\$
o
( )
2

x x
t

2
t
x

2
t
x
Introductory Econometrics for Finance Chris Brooks 2002 33
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:

Calculations:

We write

\$
( * . * . )
*( . )
. | =

=
830102 22 4165 86 65
3919654 22 4165
035
2
\$
. . * . . o = = 8665 035 4165 5912
6 . 130 , 3919654
, 65 . 86 , 5 . 416 , 22 , 830102
2
= =
= = = =

y x T y x
t
t t
t t
x y | o

+ =
t t
x y 35 . 0 12 . 59 + =
Introductory Econometrics for Finance Chris Brooks 2002 34
Example (contd)
SE(regression),

We now write the results as

( ) ( )
( )
0079 . 0
5 . 416 22 3919654
1
* 55 . 2 ) (
35 . 3
5 . 416 22 3919654 22
3919654
* 55 . 2 ) (
2
2
=

=
=

=
|
o
SE
SE
) 0079 . 0 (
35 . 0
) 35 . 3 (
12 . 59
t t
x y + =
55 . 2
20
6 . 130
2

2
= =

=

T
u
s
t
Introductory Econometrics for Finance Chris Brooks 2002 35

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:

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 coefficients
standard error.

\$
. | = 05091
) 2561 . 0 (
5091 . 0
) 38 . 14 (
3 . 20
t t
x y + =
Introductory Econometrics for Finance Chris Brooks 2002 36

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 H
0
) and the alternative hypothesis (denoted H
1
).
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
H
0
: | = 0.5
H
1
: | = 0.5
This would be known as a two sided test.

Introductory Econometrics for Finance Chris Brooks 2002 37
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:
H
0
: | = 0.5
H
1
: | > 0.5
H
0
: | = 0.5
H
1
: | < 0.5

There are two ways to conduct a hypothesis test: via the test of
significance approach or via the confidence interval approach.

Introductory Econometrics for Finance Chris Brooks 2002 38

The Probability Distribution of the
Least Squares Estimators

We assume that u
t
~ N(0,o
2
)

Since the least squares estimators are linear combinations of the random
variables
i.e.

The weighted sum of normal random variables is also normally distributed, so
~ N(o, Var(o))
~ 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.

\$
| =

w y
t t
\$
o
\$
|
Introductory Econometrics for Finance Chris Brooks 2002 39
The Probability Distribution of the
Least Squares Estimators (contd)

Standard normal variates can be constructed from and :

and

But var(o) and var(|) are unknown, so

and
\$
o
\$
|
( )
( ) 1 , 0 ~
var

N
o
o o
( )
( ) 1 , 0 ~
var

N
|
| |
2
~
) (

T
t
SE o
o o
2
~
)

T
t
SE |
| |
Introductory Econometrics for Finance Chris Brooks 2002 40

Testing Hypotheses:
The Test of Significance Approach

Assume the regression equation is given by ,
for t=1,2,...,T

The steps involved in doing a test of significance are:
1. Estimate , and , in the usual way

2. Calculate the test statistic. This is given by the formula

where is the value of | under the null hypothesis.
test statistic
SE
=

\$
*
(
\$
)
| |
|
| *
SE(
\$
) o
SE(
\$
) |
\$
o
\$
|
t t t
u x y + + = | o
Introductory Econometrics for Finance Chris Brooks 2002 41
The Test of Significance Approach (contd)

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 o. 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.

Introductory Econometrics for Finance Chris Brooks 2002 42
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)
95% non-rejection
region
2.5%
rejection region
2.5%
rejection region
Introductory Econometrics for Finance Chris Brooks 2002 43
The Rejection Region for a 1-Sided Test (Upper Tail)

f(x)
95% non-rejection
region
5% rejection region
Introductory Econometrics for Finance Chris Brooks 2002 44
The Rejection Region for a 1-Sided Test (Lower Tail)

f(x)
95% non-rejection region
5% rejection region
Introductory Econometrics for Finance Chris Brooks 2002 45
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 (H
0
), else do not reject H
0
.

Introductory Econometrics for Finance Chris Brooks 2002 46

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).

Introductory Econometrics for Finance Chris Brooks 2002 47

What Does the t-Distribution Look Like?

normal distribution
t-distribution
Introductory Econometrics for Finance Chris Brooks 2002 48
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.

Examples from statistical tables:
Significance level N(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 , the variance of the disturbances.

t N ( ) ( , ) = 01
o
2
Introductory Econometrics for Finance Chris Brooks 2002 49

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.

Introductory Econometrics for Finance Chris Brooks 2002 50

How to Carry out a Hypothesis Test
Using Confidence Intervals

1. Calculate , and , as before.

2. Choose a significance level, o, (again the convention is 5%). This is equivalent to
choosing a (1-o)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

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.
\$
o
\$
| SE(
\$
) o SE(
\$
) |
))

),

( | | | | SE t SE t
crit crit
+
Introductory Econometrics for Finance Chris Brooks 2002 51
Confidence Intervals Versus Tests of Significance
Note that the Test of Significance and Confidence Interval approaches

Under the test of significance approach, we would not reject H
0
that | = |*
if the test statistic lies within the non-rejection region, i.e. if

Rearranging, we would not reject if

But this is just the rule under the confidence interval approach.

s

s + t
SE
t
crit crit
\$
*
(
\$
)
| |
|
)

( *

( | | | | SE t SE t
crit crit
+ s s
)

* )

| | | | | SE t SE t
crit crit
+ s s
Introductory Econometrics for Finance Chris Brooks 2002 52
Constructing Tests of Significance and
Confidence Intervals: An Example

Using the regression results above,

, T=22

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 t
crit
= t
20;5%

) 2561 . 0 (
5091 . 0
) 38 . 14 (
3 . 20
t t
x y + =
Introductory Econometrics for Finance Chris Brooks 2002 53
Determining the Rejection Region

-2.086 +2.086
2.5% rejection region
2.5% rejection region
f(x)
Introductory Econometrics for Finance Chris Brooks 2002 54
Performing the Test
The hypotheses are:
H
0
: | = 1
H
1
: | = 1

Test of significance Confidence interval
approach approach

Do not reject H
0
since Since 1 lies within the
test stat lies within confidence interval,
non-rejection region do not reject H
0

test stat
SE
=

=

=
\$
*
(
\$
)
.
.
.
| |
|
05091 1
02561
1917
) 0433 . 1 , 0251 . 0 (
2561 . 0 086 . 2 5091 . 0
)

=
=
| | SE t
crit
Introductory Econometrics for Finance Chris Brooks 2002 55
Testing other Hypotheses
What if we wanted to test H
0
: | = 0 or H
0
: | = 2?

Note that we can test these with the confidence interval approach.
For interest (!), test
H
0
: | = 0
vs. H
1
: | = 0

H
0
: | = 2
vs. H
1
: | = 2

Introductory Econometrics for Finance Chris Brooks 2002 56
Changing the Size of the Test
But note that we looked at only a 5% size of test. In marginal cases
(e.g. H
0
: | = 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,

as above. The only thing that changes is the critical t-value.

test stat
SE
=

=

=
\$
*
(
\$
)
.
.
.
| |
|
05091 1
02561
1917
Introductory Econometrics for Finance Chris Brooks 2002 57
Changing the Size of the Test:
The New Rejection Regions
-1.725
+1.725
5% rejection region 5% rejection region
f(x)
Introductory Econometrics for Finance Chris Brooks 2002 58
Changing the Size of the Test:
The Conclusion

t
20;10%
= 1.725. So now, as the test statistic lies in the rejection region,
we would reject H
0
.

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).

Introductory Econometrics for Finance Chris Brooks 2002 59
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.

Introductory Econometrics for Finance Chris Brooks 2002 60
The Errors That We Can Make
Using Hypothesis Tests

We usually reject H
0
if the test statistic is statistically significant at a
chosen significance level.

There are two possible errors we could make:
1. Rejecting H
0
when it was really true. This is called a type I error.
2. Not rejecting H
0
when it was in fact false. This is called a type II error.

Reality
H
0
is true H
0
is false
Result of
Significant
(reject H
0
)
Type I error
= o
\
Test Insignificant
( do not
reject H
0
)
\
Type II error
= |
Introductory Econometrics for Finance Chris Brooks 2002 61
The Trade-off Between Type I and Type II Errors

The probability of a type I error is just o, 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:

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.
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
Introductory Econometrics for Finance Chris Brooks 2002 62
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 t
62
= 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
Introductory Econometrics for Finance Chris Brooks 2002 63
Generalising the Simple Model to
Multiple Linear Regression

Before, we have used the model
t = 1,2,...,T
But what if our dependent (y) variable depends on more than one
independent variable?
For example the number of cars sold might plausibly depend on
1. the price of cars
2. the price of public transport
3. the price of petrol
4. the extent of the publics concern about global warming
Similarly, stock returns might depend on several factors.
Having just one independent variable is no good in this case - we want to
have more than one x variable. It is very easy to generalise the simple
model to one with k-1 regressors (independent variables).

t t t
u x y + + = | o
Introductory Econometrics for Finance Chris Brooks 2002 64
Multiple Regression and the Constant Term

Now we write
, t=1,2,...,T

Where is x
1
? It is the constant term. In fact the constant term is usually
represented by a column of ones of length T:

|
1
is the coefficient attached to the constant term (which we called o before).

t kt k t t t
u x x x y + + + + + = | | | | ...
3 3 2 2 1
(
(
(
(

=
1
1
1
1

x
Introductory Econometrics for Finance Chris Brooks 2002 65
Different Ways of Expressing
the Multiple Linear Regression Model

We could write out a separate equation for every value of t:

We can write this in matrix form
y = X| +u
where y is T 1
X is T k
| is k 1
u is T 1
T kT k T T T
k k
k k
u x x x y
u x x x y
u x x x y
+ + + + + =
+ + + + + =
+ + + + + =
| | | |
| | | |
| | | |
...
...
...
3 3 2 2 1
2 2 32 3 22 2 1 2
1 1 31 3 21 2 1 1

Introductory Econometrics for Finance Chris Brooks 2002 66
Inside the Matrices of the
Multiple Linear Regression Model

e.g. if k is 2, we have 2 regressors, one of which is a column of ones:

T 1 T2 21 T1

Notice that the matrices written in this way are conformable.

(
(
(
(

+
(

(
(
(
(

=
(
(
(
(

T T T
u
u
u
x
x
x
y
y
y

2
1
2
1
2
22
21
2
1
1
1
1
|
|
Introductory Econometrics for Finance Chris Brooks 2002 67

How Do We Calculate the Parameters (the | )
in this Generalised Case?
Previously, we took the residual sum of squares, and minimised it
w.r.t. o and |.
In the matrix notation, we have

The RSS would be given by

(
(
(
(

=
T
u
u
u
u

2
1

| |

= + + + =
(
(
(
(

=
2 2 2
2
2
1
2
1
2 1
...

'
t T
T
T
u u u u
u
u
u
u u u u u
Introductory Econometrics for Finance Chris Brooks 2002 68
The OLS Estimator for the
Multiple Regression Model
In order to obtain the parameter estimates, |
1
, |
2
,..., |
k
, we would
minimise the RSS with respect to all the |s.

It can be shown that

y X X X
k
' ' =
(
(
(
(
(

=
1 2
1
) (

|
|
|
|

## Introductory Econometrics for Finance Chris Brooks 2002 69

Calculating the Standard Errors for the
Multiple Regression Model
Check the dimensions: is k 1 as required.

But how do we calculate the standard errors of the coefficient estimates?

Previously, to estimate the variance of the errors, o
2
, we used .

Now using the matrix notation, we use

where k = number of regressors. It can be proved that the OLS estimator of
the variance of is given by the diagonal elements of , so that
the variance of is the first element, the variance of is the second
element, and , and the variance of is the k
th
diagonal element.

\$
|
s
u u
T k
2
=

\$' \$
\$
| s X X
2 1
( ' )

\$
|
1
\$
|
2
\$
|
k
2

2
2

T
u
s
t
Introductory Econometrics for Finance Chris Brooks 2002 70
Calculating Parameter and Standard Error Estimates
for Multiple Regression Models: An Example
Example: The following model with k=3 is estimated over 15 observations:

and the following data have been calculated from the original Xs.

Calculate the coefficient estimates and their standard errors.
To calculate the coefficients, just multiply the matrix by the vector to obtain
.
To calculate the standard errors, we need an estimate of o
2
.

( ' )
. . .
. . .
. . .
, ( ' )
.
.
.
, \$' \$ . X X X y u u

(
(
=

(
(
=
1
20 35 10
35 10 65
10 65 43
30
22
06
1096
s
T k
2
1096
15 3
091 =

=

=
.
.
u x x y + + + =
3 3 2 2 1
| | |
( ) y X X X ' '
1
Introductory Econometrics for Finance Chris Brooks 2002 71
Calculating Parameter and Standard Error Estimates
for Multiple Regression Models: An Example (contd)
The variance-covariance matrix of is given by

The variances are on the leading diagonal:

We write:

\$
|
s X X X X
2 1 1
091
183 320 091
320 091 594
091 594 393
( ' ) . ( ' )
. . .
. . .
. . .

= =

(
(
Var SE
Var SE
Var SE
(
\$
) . (
\$
) .
(
\$
) . (
\$
) .
(
\$
) . (
\$
) .
| |
| |
| |
1 1
2 2
3 3
183 135
0 91 0 96
393 198
= =
= =
= =
( ) ( ) ( ) 98 . 1 96 . 0 35 . 1
88 . 19 40 . 4 10 . 1
3 2 t t
x x y + =
Introductory Econometrics for Finance Chris Brooks 2002 72

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

If the test is H
0
: |
i
= 0
H
1
: |
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,

The ratio of the coefficient to its SE is known as the t-ratio or t-statistic.
( )
test statistic
SE
i i
i
=

\$
\$
*
| |
|
test stat
SE
i
i
=
\$
(
\$
)
|
|
Introductory Econometrics for Finance Chris Brooks 2002 73

The t-ratio: An Example

In the last example above:
Coefficient 1.10 -4.40 19.88
SE 1.35 0.96 1.98
t-ratio 0.81 -4.63 10.04

Compare this with a t
crit
with 15-3 = 12 d.f.
(2% in each tail for a 5% test) = 2.179 5%
= 3.055 1%

Do we reject H
0
: |
1
= 0? (No)
H
0
: |
2
= 0? (Yes)
H
0
: |
3
= 0? (Yes)

Introductory Econometrics for Finance Chris Brooks 2002 74

What Does the t-ratio tell us?

If we reject H
0
, 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 significant. Look at what happens if no intercept is included:

t
y
t
x
Introductory Econometrics for Finance Chris Brooks 2002 75
Data Mining
Data mining is searching many series for statistical relationships
without theoretical justification.

For example, suppose we generate one dependent variable and twenty
explanatory variables completely randomly and independently of each
other.

If we regress the dependent variable separately on each independent
variable, on average one slope coefficient will be significant at 5%.

If data mining occurs, the true significance level will be greater than
the nominal significance level.
Introductory Econometrics for Finance Chris Brooks 2002 76
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 (Jensens
alpha - Jensen, 1968).

The Data: Annual Returns on the portfolios of 115 mutual funds from
1945-1964.

The model: for j = 1, , 115

We are interested in the significance of o
j
.

The null hypothesis is H
0
: o
j
= 0 .

jt ft mt j j ft jt
u R R R R + + = ) ( | o
Introductory Econometrics for Finance Chris Brooks 2002 77
Frequency Distribution of t-ratios of Mutual Fund
Alphas (gross of transactions costs)

Source Jensen (1968). Reprinted with the permission of Blackwell publishers.
Introductory Econometrics for Finance Chris Brooks 2002 78
Frequency Distribution of t-ratios of Mutual Fund
Alphas (net of transactions costs)

Source Jensen (1968). Reprinted with the permission of Blackwell publishers.

Introductory Econometrics for Finance Chris Brooks 2002 79

Can UK Unit Trust Managers Beat the Market?

We now perform a variant on Jensens test in the context of the UK market,
considering monthly returns on 76 equity unit trusts. The data cover the
period January 1979 May 2000 (257 observations for each fund). Some
summary statistics for the funds are:
Mean Minimum Maximum Median
Average monthly return, 1979-2000 1.0% 0.6% 1.4% 1.0%
Standard deviation of returns over time 5.1% 4.3% 6.9% 5.0%

Jensen Regression Results for UK Unit Trust Returns, January 1979-May
2000

R R R R
jt ft j j mt ft jt
= + + o | c ( )
Introductory Econometrics for Finance Chris Brooks 2002 80
Can UK Unit Trust Managers Beat the Market?
: Results
Estimates of Mean Minimum Maximum Median
o -0.02% -0.54% 0.33% -0.03%
| 0.91 0.56 1.09 0.91
t-ratio on o -0.07 -2.44 3.11 -0.25

In fact, gross of transactions costs, 9 funds of the sample of 76 were
able to significantly out-perform the market by providing a significant
positive alpha, while 7 funds yielded significant negative alphas.

Introductory Econometrics for Finance Chris Brooks 2002 81
Performance of UK Unit Trusts 1979-2000
0
500
1000
1500
2000
2500
3000
3500
J
a
n
-
7
9
J
a
n
-
8
0
J
a
n
-
8
1
J
a
n
-
8
2
J
a
n
-
8
3
J
a
n
-
8
4
J
a
n
-
8
5
J
a
n
-
8
6
J
a
n
-
8
7
J
a
n
-
8
8
J
a
n
-
8
9
J
a
n
-
9
0
J
a
n
-
9
1
J
a
n
-
9
2
J
a
n
-
9
3
J
a
n
-
9
4
J
a
n
-
9
5
J
a
n
-
9
6
J
a
n
-
9
7
J
a
n
-
9
8
J
a
n
-
9
9
J
a
n
-
0
0
Introductory Econometrics for Finance Chris Brooks 2002 82

The Overreaction Hypothesis and
the UK Stock Market

Motivation
Two studies by DeBondt and Thaler (1985, 1987) showed that stocks which
experience a poor performance over a 3 to 5 year period tend to outperform
stocks which had previously performed relatively well.
How Can This be Explained?
2 suggestions
1. A manifestation of the size effect
DeBondt & Thaler did not believe this a sufficient explanation, but Zarowin
(1990) found that allowing for firm size did reduce the subsequent return on
the losers.
2. Reversals reflect changes in equilibrium required returns
Ball & Kothari (1989) find the CAPM beta of losers to be considerably
higher than that of winners.
Introductory Econometrics for Finance Chris Brooks 2002 83
The Overreaction Hypothesis and
the UK Stock Market (contd)

Another interesting anomaly: the January effect.
Another possible reason for the superior subsequent performance
of losers.
Zarowin (1990) finds that 80% of the extra return available from
holding the losers accrues to investors in January.

Example study: Clare and Thomas (1995)
Data:
Monthly UK stock returns from January 1955 to 1990 on all firms
traded on the London Stock exchange.

Introductory Econometrics for Finance Chris Brooks 2002 84

Methodology

Calculate the monthly excess return of the stock over the market over a 12,
24 or 36 month period for each stock i:

U
it
= R
it
- R
mt
n = 12, 24 or 36 months

Calculate the average monthly return for the stock i over the first 12, 24, or
36 month period:

R
n
U
i it
t
n
=
=

1
1
Introductory Econometrics for Finance Chris Brooks 2002 85
Portfolio Formation

Then rank the stocks from highest average return to lowest and from 5
portfolios:

Portfolio 1: Best performing 20% of firms
Portfolio 2: Next 20%
Portfolio 3: Next 20%
Portfolio 4: Next 20%
Portfolio 5: Worst performing 20% of firms.

Use the same sample length n to monitor the performance of each
portfolio.

Introductory Econometrics for Finance Chris Brooks 2002 86
Portfolio Formation and
Portfolio Tracking Periods

How many samples of length n have we got?
n = 1, 2, or 3 years.

If n = 1year:
Estimate for year 1
Monitor portfolios for year 2
Estimate for year 3
...
Monitor portfolios for year 36

So if n = 1, we have 18 INDEPENDENT (non-overlapping) observation /
tracking periods.
Introductory Econometrics for Finance Chris Brooks 2002 87
Constructing Winner and Loser Returns

Similarly, n = 2 gives 9 independent periods and n = 3 gives 6 independent
periods.
Calculate monthly portfolio returns assuming an equal weighting of stocks in
each portfolio.
Denote the mean return for each month over the 18, 9 or 6 periods for the
winner and loser portfolios respectively as and respectively.

Define the difference between these as = - .

Then perform the regression
= o
1
+ q
t
(Test 1)

Look at the significance of o
1
.
R
p
W
R
p
L
R
Dt
R
p
L
R
p
W
R
Dt
Introductory Econometrics for Finance Chris Brooks 2002 88
Allowing for Differences in the Riskiness
of the Winner and Loser Portfolios

Problem: Significant and positive o
1
could be due to higher return being
required on loser stocks due to loser stocks being more risky.

Solution: Allow for risk differences by regressing against the market risk

= o
2
+ |(R
mt
-R
ft
) + q
t
(Test 2)

where
R
mt
is the return on the FTA All-share
R
ft
is the return on a UK government 3 month t-bill.

R
Dt
Introductory Econometrics for Finance Chris Brooks 2002 89
Is there an Overreaction Effect in the
UK Stock Market? Results

Panel A: All Months
n = 12 n = 24 n =36
Return on Loser 0.0033 0.0011 0.0129
Return on Winner 0.0036 -0.0003 0.0115
Implied annualised return difference -0.37% 1.68% 1.56%

Coefficient for (3.47):
1
o

-0.00031
(0.29)
0.0014**
(2.01)
0.0013
(1.55)

Coefficients for (3.48):
2
o

-0.00034
(-0.30)
0.00147**
(2.01)
0.0013*
(1.41)

|

-0.022
(-0.25)
0.010
(0.21)
-0.0025
(-0.06)
Panel B: All Months Except January
Coefficient for (3.47): 1
o

-0.0007
(-0.72)
0.0012*
(1.63)
0.0009
(1.05)
Notes: t-ratios in parentheses; * and ** denote significance at the 10% and 5% levels
respectively. Source: Clare and Thomas (1995). Reprinted with the permission of Blackwell
Publishers.
Introductory Econometrics for Finance Chris Brooks 2002 90
Are the Losers Small?

Rank the firms according to size
i = 1 smallest 20% of firms
...
i = 5 largest 20% of firms

Then also rank firms according to their average return as previously.

j = 1 worst performing 20% of firms
...
j = 5 best performing 20% of firms

Introductory Econometrics for Finance Chris Brooks 2002 91
Portfolio Ranking by Performance and Size

So is the return on the i
th
sized portfolio and the j
th
return ranking
portfolio (dropping time subscripts for simplicity)m, so

R
ij
R R R
D
1 11 51
= (4)
R R R
D
2 12 52
=
(5)
R R R
D
3 13 53
=
(6)
R R R
D
4 14 54
=
(7)
R R R
D
5 15 55
=
(8)
Introductory Econometrics for Finance Chris Brooks 2002 92
Overreaction versus Small Firm Effects for
a 1-Year Horizon

Panel A: All Months Regression Equation
(3.57) (3.58) (3.59) (3.60) (3.61)
Return on Loser 0.00109 0.00509 0.00583 0.00825 0.00778
Return on Winner -0.00141 0.00116 0.00415 0.00473 0.00457

Coefficient for Test 1:
1
o

0.0025
(0.93)
0.0040
(1.30)
0.0017
(0.80)
0.0035
(1.05)
0.0032
(1.06)

Coefficients for Test 2:
2
o

0.0023
(0.83)
0.0032
(1.73)
0.0014
(0.69)
0.0028
(1.12)
0.026
(1.06)

|

-0.21
(-0.99)
-0.63**
(-4.50)
-0.258
(-1.68)
-0.625**
(-3.24)
-0.50**
(-2.63)
Panel B: All Months Except January
Coefficient for Test 1:
1
o

-0.0011
(-0.44)
0.0035
(1.09)
0.002
(0.94)
0.0027
(0.75)
0.0038
(1.16)
Notes: t-ratios in parentheses; * and ** denote significance at the 10% and 5% levels respectively.
Source: Clare and Thomas (1995). Reprinted with the permission of Blackwell Publishers.
Introductory Econometrics for Finance Chris Brooks 2002 93
Overreaction versus Small Firm Effects for
a 2-Year Horizon

Panel A: All Months Regression Equation
(3.57) (3.58) (3.59) (3.60) (3.61)
Return on Loser 0.00591 0.0080 0.00715 0.0044 0.00708
Return on Winner 0.00218 0.0026 0.00197 0.0002 -0.00057

Coefficient for Test 1:
1
o

0.0037
(1.39)
0.0053**
(2.01)
0.0052**
(1.97)
0.0042**
(1.91)
0.008**
(3.03)

Coefficients for Test 2:
2
o

0.0035
(1.23)
0.004
(1.56)
0.0034
(1.45)
0.0035
(1.54)
0.0068**
(2.64)

|

-0.024
(-0.34)
-0.129**
(-2.08)
-0.167**
(-2.90)
-0.075
(-1.37)
-0.09
(-1.40)
Panel B: All Months Except January
Coefficient for Test 1:
1
o

0.0028
(0.99)
0.0054*
(1.92)
0.005*
(1.86)
0.0037
(1.60)
0.009**
(3.42)
Notes: t-ratios in parentheses; * and ** denote significance at the 10% and 5% levels respectively.
Source: Clare and Thomas (1995). Reprinted with the permission of Blackwell Publishers.
Introductory Econometrics for Finance Chris Brooks 2002 94
Overreaction versus Small Firm Effects for
a 3-Year Horizon

Panel A: All Months Regression Equation
(3.57) (3.58) (3.59) (3.60) (3.61)
Return on Loser 0.01591 0.01484 0.01477 0.01202 0.12420
Return on Winner 0.01155 0.01335 0.01176 0.01130 0.00856

Coefficient for Test 1:
1
o

0.0044
(1.55)
0.0015
(0.55)
0.003
(1.21)
0.0007
(0.21)
0.0039
(1.13)

Coefficients for Test 2:
2
o

0.0071**
(2.56)
0.0046*
(1.87)
0.0054**
(2.21)
0.005
(1.45)
0.0071**
(2.14)

|

-0.26**
(-2.80)
-0.30**
(-3.63)
-0.23**
(-2.77)
-0.38**
(-3.50)
-0.32**
(-2.81)
Panel B: All Months Except January
Coefficient for Test 1:
1
o

0.0046*
(1.73)
0.001
(0.37)
0.0024
(1.01)
0.00004
(0.01)
0.003
(0.94)
Notes: t-ratios in parentheses; * and ** denote significance at the 10% and 5% levels respectively.
Source: Clare and Thomas (1995). Reprinted with the permission of Blackwell Publishers.
Introductory Econometrics for Finance Chris Brooks 2002 95

Testing for Seasonal Effects in Overreactions

Is there evidence that losers out-perform winners more at one time of the
year than another?

To test this, calculate the difference between the winner & loser portfolios
as previously, , and regress this on 12 month-of-the-year dummies:

Significant out-performance of losers over winners in,
June (for the 24-month horizon), and
January, April and October (for the 36-month horizon)
winners appear to stay significantly as winners in
March (for the 12-month horizon).

R M
Dt i i t
i
= +
=

o v
1
12
R
Dt
Introductory Econometrics for Finance Chris Brooks 2002 96
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.

Small samples
No diagnostic checks of model adequacy

Introductory Econometrics for Finance Chris Brooks 2002 97
Testing Multiple Hypotheses: The F-test
We used the t-test to test single hypotheses, i.e. hypotheses involving only
one coefficient. But what if we want to test more than one coefficient
simultaneously?

We do this using the F-test. The F-test involves estimating 2 regressions.

The unrestricted regression is the one in which the coefficients are freely
determined by the data, as we have done before.

The restricted regression is the one in which the coefficients are restricted,
i.e. the restrictions are imposed on some |s.

Introductory Econometrics for Finance Chris Brooks 2002 98
The F-test:
Restricted and Unrestricted Regressions

Example
The general regression is
y
t
= |
1
+ |
2
x
2t
+ |
3
x
3t
+ |
4
x
4t
+ u
t
(1)

We want to test the restriction that |
3
+|
4
= 1 (we have some hypothesis
from theory which suggests that this would be an interesting hypothesis to
study). The unrestricted regression is (1) above, but what is the restricted
regression?
y
t
= |
1
+ |
2
x
2t
+ |
3
x
3t
+ |
4
x
4t
+ u
t
s.t. |
3
+|
4
= 1

We substitute the restriction (|
3
+|
4
= 1) into the regression so that it is
automatically imposed on the data.
|
3
+|
4
= 1 |
4
= 1- |
3

Introductory Econometrics for Finance Chris Brooks 2002 99
The F-test: Forming the Restricted Regression

y
t
= |
1
+ |
2
x
2t
+ |
3
x
3t
+ (1-|
3
)x
4t
+ u
t

y
t
= |
1
+ |
2
x
2t
+ |
3
x
3t
+ x
4t
- |
3
x
4t
+ u
t

Gather terms in |s together and rearrange
(y
t
- x
4t
) = |
1
+ |
2
x
2t
+ |
3
(x
3t
- x
4t
) + u
t

This is the restricted regression. We actually estimate it by creating two new
variables, call them, say, P
t
and Q
t
.
P
t
= y
t
- x
4t

Q
t
= x
3t
- x
4t
so
P
t
= |
1
+ |
2
x
2t
+ |
3
Q
t
+ u
t
is the restricted regression we actually estimate.
Introductory Econometrics for Finance Chris Brooks 2002 100
Calculating the F-Test Statistic

The test statistic is given by

m = number of restrictions
T = number of observations
k = number of regressors in unrestricted regression
including a constant in the unrestricted regression (or the total number
of parameters to be estimated).
test statistic
T k
m
=

Introductory Econometrics for Finance Chris Brooks 2002 101
The F-Distribution
The test statistic follows the F-distribution, which has 2 d.f.
parameters.

The value of the degrees of freedom parameters are m and (T-k)
respectively (the order of the d.f. parameters is important).

The appropriate critical value will be in column m, row (T-k).

The F-distribution has only positive values and is not symmetrical. We
therefore only reject the null if the test statistic > critical F-value.

Introductory Econometrics for Finance Chris Brooks 2002 102
Determining the Number of Restrictions in an F-test
Examples :
H
0
: hypothesis No. of restrictions, m
|
1
+ |
2
= 2 1
|
2
= 1 and |
3
= -1 2
|
2
= 0, |
3
= 0 and |
4
= 0 3
If the model is y
t
= |
1
+ |
2
x
2t
+ |
3
x
3t
+ |
4
x
4t
+ u
t
,
then the null hypothesis
H
0
: |
2
= 0, and |
3
= 0 and |
4
= 0 is tested by the regression F-statistic. It
tests the null hypothesis that all of the coefficients except the intercept
coefficient are zero.
Note the form of the alternative hypothesis for all tests when more than one
restriction is involved: H
1
: |
2
= 0, or |
3
= 0 or |
4
= 0
Introductory Econometrics for Finance Chris Brooks 2002 103
What we Cannot Test with Either an F or a t-test

We cannot test using this framework hypotheses which are not linear
or which are multiplicative, e.g.
H
0
: |
2
|
3
= 2 or H
0
: |
2
2

= 1
cannot be tested.

Introductory Econometrics for Finance Chris Brooks 2002 104
The Relationship between the t and the F-
Distributions

Any hypothesis which could be tested with a t-test could have been
tested using an F-test, but not the other way around.

For example, consider the hypothesis
H
0
: |
2
= 0.5
H
1
: |
2
= 0.5
We could have tested this using the usual t-test:

or it could be tested in the framework above for the F-test.
Note that the two tests always give the same result since the t-
distribution is just a special case of the F-distribution.
For example, if we have some random variable Z, and Z ~ t

(T-k) then
also Z
2
~ F(1,T-k)
test stat
SE
=

\$
.
(
\$
)
|
|
2
2
05
Introductory Econometrics for Finance Chris Brooks 2002 105
F-test Example

Question: Suppose a researcher wants to test whether the returns on a company
stock (y) show unit sensitivity to two factors (factor x
2
and factor x
3
) among three
considered. The regression is carried out on 144 monthly observations. The
regression is y
t
= |
1
+ |
2
x
2t
+ |
3
x
3t
+ |
4
x
4t
+ u
t

- What are the restricted and unrestricted regressions?
- If the two RSS are 436.1 and 397.2 respectively, perform the test.
Solution:
Unit sensitivity implies H
0
:|
2
=1 and |
3
=1. The unrestricted regression is the one
in the question. The restricted regression is (y
t
-x
2t
-x
3t
)= |
1
+ |
4
x
4t
+u
t
or letting
z
t
=y
t
-x
2t
-x
3t
, the restricted regression is z
t
= |
1
+ |
4
x
4t
+u
t