Australian School Of Business FINS4479/5579: Research Methods in Finance 2 Semester 1 2014

Individual Assignment #1 Due: 31 March 2014

1. Introduction and OLS review (a) Stock and Watson Exercise 6.6 (b) Stock and Watson Exercise 6.8 (c) Stock and Watson Empirical Exercise E6.1 2. Instrumental variables (a) Stock and Watson Exercise 12.5 This question is asking which assumption of the two assumptions in concept 12.3, Instrument Relevance and Instrument Exogeneity, do not hold. (b) Stock and Watson Exercise 12.9 (c) Stock and Watson Empirical Exercise E12.1

3. Estimator derivation Maximum likelihood estimation emphasizes an underlying distributional assumption when deriving the estimator. Given a sample of Xi and Yi , maximum likelihood nds a parameter vector that maximizes the probability of observing the sample data. Informally, this means that maximum likelihood ts the data to an assumed distribution. For a discrete random variable and independent observations, maximum likelihood nds a parameter vector, , that maximizes: P (Y1 , Y2 , . . . YN |X1 , X2 , . . . XN ; ) =P (Y1 |X1 ; ) P (Y2 |X2 ; ) . . . P (YN |XN ; ) where P (Yi |Xi ; ) is the probability of observing Yi given Xi and . When the dependent variable has a continuous density function f , the maximum likelihood estimator maximizes the product of the probability density functions f (Y1 , Y2 , . . . YN |X1 , X2 , . . . XN ; ) = f (Y1 |X1 ; ) f (Y2 |X2 ; ) . . . f (YN |XN ; ) (1) (a) The OLS model is y = x + u. Canonical OLS assumes that the disturbances u are independent, identical, and normally distributed with a variance of 2 . Given this, what is the conditional distribution of y given x? That is (i) what type of conditional distribution does y have, (ii) what is the conditional mean, and (iii) what is the conditional variance? (b) Given a normally distributed random variable z with a conditional mean of and a variance of 2 , the normal distribution density function is
(z )2 1 f (z ) = e 22 2

What is f (Y |X ; )? (c) Instead of maximizing equation (1), maximum likelihood proceeds by rst taking logs. Write the logarithm of equation (1) using sigma () notation. (d) Substitute your expression from part (b) into your expression from part (c). Simplify. (e) What is the rst order condition for in part (d)? (f) What is the estimator for ? How does this dier from OLS? (g) What assumption do you think is required for the estimator you just derived to be consistent?