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- The Interpretation of Statistical Results
- FinQuiz - Curriculum Note, Study Session 11, Reading 35
- FinQuiz - Curriculum Note, Study Session 11, Reading 36
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FinQuiz Notes 2 0 1 5

2. CORRELATION ANALYSIS

Scatter plot and correlation analysis are used to examine portfolio could be diversified or decreased.

how two sets of data are related. If there is zero covariance between two assets, it

means that there is no relationship between the

2.1 Scatter Plots rates of return of two assets and the assets can be

included in the same portfolio.

A scatter plot graphically shows the relationship

between two varaibles. If the points on the scatter plot Correlation coefficient measures the direction and

cluster together in a straight line, the two variables have strength of linear association between two variables. The

a strong linear relation. Observations in the scatter plot correlation coefficient between two assets X and Y can

are represented by a point, and the points are not be calculated using the following formula:

=

connected.

! "#$ !% % ! "#$ !% %

2.2 & Correlation Analysis & Calculating and

=

& &

2.3 Interpreting the Correlation Coefficient

(, *

or

= '=

1

+ ,' ( + ,' *

where,

n = sample size NOTE:

Xi = ith observation on variable X

= mean of the variable X observations Unlike Covariance, Correlation has no unit of

Yi = ith observation on variable Y measurement; it is a simple number.

= mean of the variable Y observations

Example:

The covariance of a random variable with itself is - ./ = 47.78 4.5 = 40 4/5 = 250

47.78

simply a variance of the random variable.

'= = 0.478

Covariance can range from to + .

The covariance number doesnt tell the investor if + 40 250

the relationship between two variables (e.g.

returns of two assets X and ) is strong or weak. It

The correlation coefficient can range from -1 to

only tells the direction of this relationship. For

+1.

example,

Two variables are perfectly positively correlated

o Positive number of covariance shows that rates

if correlation coefficient is +1.

of return of two assets are moving in the same

Correlation coefficient of -1 indicates a perfect

direction: when the rate of return of asset X is

inverse (negative) linear relationship between

negative, the returns of other asset tend to be

the returns of two assets.

negative as well and vice versa.

When correlation coefficient equals 0, there is

o Negative number of covariance shows that rates

no linear relationship between the returns of

of return of two assets are moving in the opposite

two assets.

directions: when return on asset X is positive, the

The closer the correlation coefficient is to 1, the

returns of the other asset Y tend to be negative

stronger the relationship between the returns of

and vice versa.

two assets.

slope of the line is +/- 1.

If there is positive covariance between two assets

then the investor should evaluate whether or not NOTE:

he/she should include both of these assets in the

same portfolio, because their returns move in the Combining two assets that have zero correlation with

same direction and the risk in portfolio may not be each other reduces the risk of the portfolio. A negative

diversified. correlation coefficient results in greater risk reduction.

If there is negative covariance between the pair of

assets then the investor should include both of

these assets to the portfolio, because their returns

move in the opposite directions and the risk in

Reading 9 Correlation and Regression FinQuiz.com

population is different from 0 ( 0);

NOTE:

The null hypothesis is the hypothesis to be tested. The

alternative hypothesis is the hypothesis that is accepted

if the null is rejected.

variables):

' 2

9= ~9 2

Difference b/w Covariance & Correlation: The

covariance primarily provides information to the investor 1 ' 5

about whether the relationship between asset returns is where,

positive, negative or zero, but correlation coefficient tells

r is the sample coefficient of correlation calculated by

the degree of relationship between assets returns.

,

'=

<= <>

NOTE:

Correlation coefficients are valid only if the means,

variances & covariances of X and Y are finite and t = t-statistic (or calculated t)

constant. When these assumptions do not hold, then the n 2 = degrees of freedom

correlation between two different variables depends

largely on the sample selected. Decision Rule:

If test statistic is < t-critical or > + t-critical with n-2

2.4 Limitations of Correlation Analysis degrees of freedom, (if absolute value of t > tc), Reject

H0; otherwise Do not Reject H0.

relationships properly.

Suppose r = 0.886 and n = 8, and tC = 2.4469 (at 5%

2. Outliers: Correlation may be an unreliable measure significance level i.e. = 5%/2 and degrees of freedom =

when outliers are present in one or both of the series. 8 2 = 6)

8 2

t = 0.886 = 4.68 Since t-value > tc, we reject

3. No proof of causation: Based on correlation we 1 (0.886)2

cannot assume x causes y; there could be third

variable causing change in both variables. null hypothsis of no correlation.

correlation in the data without any causal

relationship. This may occur when:

ii. two variables that are uncorrelated but may be

correlated if mixed by third variable .

iii. correlation between two variables resulting from a

third variable.

NOTE:

Spurious correlation may suggest investment strategies

that appear profitable but actually would not be so, if Magnitute of r needed to reject the null hypothesis (H0:

implemented. = 0) decreases as sample size n increases. Because

as n increases the:

Testing the Significance of the Correlation o number of degrees of freedom increases

2.6 o absolute value of tc decreases.

Coefficient

o t-value increases

t-test is used to determine if sample correlation

coefficient, r, is statistically significant. In other words, type II error decreases when sample size

(n) increases, all else equal.

Two-Tailed Test:

Null Hypothesis H0 : the correlation in the population is 0

( = 0);

Reading 9 Correlation and Regression FinQuiz.com

NOTE:

Type I error = reject the null hypothesis although it is true. Practice: Example 7, 8, 9 & 10

Type II error = do not reject the null hypothesis although Volume 1, Reading 9.

it is wrong.

3. LINEAR REGRESSION

Regression analysis is used to: Independent variable: The variable used to explain the

dependent variable. Also called exogenous or

Predict the value of a dependent variable based on predicting variable.

the value of at least one independent variable

Explain the impact of changes in an independent Intercept (b0): The predicted value of the dependent

variable on the dependent variable. variable when the independent variable is set to zero.

b0 = y b1 x

Linear regression assumes a linear relationship between

the dependent and the independent variables. Linear Slope Coefficient or regression coefficient (b1): A

regression is also known as linear least squares since it change in the dependent variable for a unit change in

selects values for the intercept b0 and slope b1 that

(, *

the independent variable.

? =

minimize the sum of the squared vertical distances

between the observations and the regression line. ,' (

( ( * *

or

? =

Estimated Regression Model: The sample regression line

provides an estimate of the population regression line. ( ( 5

Note that population parameter values b0 and b1 are

not observeable; only estimates of b0 and b1 are Error Term: It represents a portion of the dependent

observeable. variable that cannot be explained by the independent

varaiable.

Example:

n =100

s x2 = = 43,528,688

i

n 1

y = 5,411 .41; (x x)( yi y )

cov( X , Y ) = = 1,356,256

i

n 1

y = b0 + b1 x = 6,535 0.0312 x

cov( X , Y ) 1,356,256

b1 = = = 0.0312

s x2 43,528,688

b0 = y b1 x = 5,411.41 ( 0.0312)(36,009.45) = 6,535

1) Time-series: It uses many observations from different

time periods for the same company, asset class or

country etc.

same time periodof different companies, asset classes

or countries etc.

data.

predicted) by the independent variable. Also called

endogenous or predicted variable.

Reading 9 Correlation and Regression FinQuiz.com

3.2 Assumptions of the Linear Regression Model 3.4 The Coefficient of Determination

1. The regression model is linear in its parameters b0 and The coefficient of determination is the portion of the

b1 i.e. b0 and b1 are raised to power 1 only and total variation in the dependent variable that is

neither b0 nor b1 is multiplied or divided by another explained by the independent variable. The coefficient

regression parameter e.g. b0 / b1. of determination is also called R-squared and is denoted

as R2.

When regression model is nonlinear in parameters,

regression results are invalid.

M 9,N O,'D,9D 44M P F(QN,D FA O,'D,9D 44B

Even if the dependent variable is nonlinear but

=

M 9,N O,'D,9D 44M

parameters are linear, linear regression can be used.

=

2. Independent variables and residuals are

M 9,N O,'D,9D 44M

uncorrelated.

3. The expected value of the error term is 0.

where,

When assumptiuons 2 & 3 hold, linear regression

produces the correct estimates of b0 and b1. 0 R 2 1

4. The variance of the error term is the same for all In case of a single independent variable, the coefficient

observations. (It is known as Homoskedasticity of determination is: R2 = r2

assumption).

5. Error values () are statistically independent i.e. the where,

error for one observation is not correlated with any

R2 = Coefficient of determination

other observation.

r = Simple correlation coefficient

6. Error values are normally distributed for any given

value of x.

Example:

3.3 The Standard Error of Estimate Suppose correlation coefficient between returns of two

assets is + 0.80, then the coefficient of determination will

Standard Error of Estimate (SEE) measures the degree of be 0.64. The interpretation of this number is that

variability of the actual y-values relative to the estimated approximately 64 percent of the variability in the returns

(predicted) y-values from a regression equation. Smaller of one asset (or dependent variable) can be explained

the SEE, better the fit. by the returns of the other asset (or indepepnent

44B

variable). If the returns on two assets are perfectly

49, A,'A B'' ' C B&9DE,9F: 4H = I

J1

correlated (r = +/- 1), the coefficient of determination will

be equal to 100 %, and this means that if changes in

or returns of one asset are known, then we can exactly

* *K 5 44B

predict the returns of the other asset.

4BB = 4H = I =I ,

J1 J1 NOTE:

Multiple R is the correlation between the actual values

where, and the predicted values of Y. The coefficient of

SSE = Sum of squares error determination is the square of multiple R.

n = Sample size

k = number of independent variables in the model Total variation is made up of two parts:

SST = SSE + SSR(or RSS)

Example:

n = 100

SSE = 2,252,363

Thus,

s = = = 151 .60 where,

n2 98

y = Average value of the dependent variable

Regression Residual is the difference between the actual y = Observed values of the dependent variable

values of dependent variable and the predicted value

of the dependent variable made by regression

equation. SST (total sum of squares): Measures total variation

Reading 9 Correlation and Regression FinQuiz.com

yi values around their mean y. df = n - 2

SSE (error sum of squares): Measures unexplained

variation in the dependent variable.

SSR / RSS (regression sum of squares): Measures Example:

variation in the dependent variable explained by ^ ^

9.01 0

T .S . : tobs = = 6.01 R.R. :| tobs | t.025,5 = 2.571

1.50

9.01 2.571(1.50) = 9.01 3.86 = (12.87 to 5.15)

Therefore, we can say with 95% confidence that the

regression slope is different from 0.

Practice: Example 13

Volume 1, Reading 9.

Reject H0 because t-value 6.01 > critical tc 2.571.

NOTE:

3.5 Hypothesis Testing

Higher level of confidence or lower level of significance

results in higher values of critical t i.e. tc. This implies

In order to determine whether there is a linear that:

relationship between x and y or not, significance test (i.e.

t-test) is used instead of just relying on b1 value. t-statistic Confidence intervals will be larger.

is used to test the significance of the individual Probability of rejecting the H0 decreases i.e. type II

coefficients (e.g. slope) in a regression. error increases.

The probability of Type-I error decreases.

Null and Alternative hypotheses

Stronger regression results lead to smaller standard errors

H0: b1 = 0 (no linear relationship)

of an estimated parameter and result in tighter

H1: b1 0 (linear relationship does exist)

) confidence interval. As a result probability of rejecting H0

b1 b1 increases (or probability of Type-I error increases).

Test statistic = t=

s b1 p-value: The p-value is the smallest level of significance

where, at which the null hypothesis can be rejected.

?S1 = Sample regression slope coefficient

Decision Rule: If p < significance level, H0 can be

b1 = Hypothesized slope

4T = Standard error of the slope

rejected. If p > significance level, H0 cannot be rejected.

level is 5%, we can reject the hypothesis that true

Decision Rule: parameter equals 0.

If test statistic is < t-critical or > + t-critical with n-2

degrees of freedom, (if absolute value of t > tc), Reject

H0; otherwise Do not Reject H0. Practice: Example 14, 15 & 16

Volume 1, Reading 9.

Two-Sided Test One-sided Test

H0: b1 = 0 H0: b1 = 0

HA: b1 0 HA+: b1> 0or

HA-: b1< 0 Analysis of Variance in a Regression with One

3.6

Independent Variable

Confidence Interval Estimate of the Slope: Confidence

interval is an interval of values that is expected to Analysis of Variance (ANOVA) is a statistical method

include the true parameter value b1 with a given degree used to divide the total variance in a study into

of freedom. meaningful pieces that correspond to different sources.

In regression analysis, ANOVA is used to determine the

Reading 9 Correlation and Regression FinQuiz.com

explaining the variation in dependent variable.

Practice: Example 17

Volume 1, Reading 9.

ANOVA df SS MSS F

44L

44LV

44L J

= U *K 44BV

J

3.7 Prediction Intervals

J1

Regression k

* 5

[ \ ]^ _`

44B

44B

c f a

where,

=U *

nk

J1 _a` = _a bc d d g

Error

e e c _a

1

*K 5

44M

and

s f = s 2f

Total n1 =U *

* 5

s2 = squared SEE

n = number of observations

Or X = value of independent variable

= estimated mean of X

s2X= variance of independent variable

Source of Sum of Mean Sum of

DoF tc = critical t-value for n k 1 degrees of freedom.

Variability Squares Squares

Regression Example:

1 RSS MSR = RSS/1

(Explained)

Calculate a 95% prediction interval on the predicted

Error value of Y. Assume the standard error of the forecast is

n-2 SSE MSE = SSE/n-2

(Unexplained) 3.50%, and the forecasted value of X is 8%. And n = 36.

Assume: Y = 3% + (0.50)(X)

Total n-1 SST=RSS + SSE

The predicted value for Y is: Y =3% + (0.50)(8%)= 7%

F-Statistic or F-Test evaluates how well a set of

independent variables, as a group, explains the variation The 5% two-tailed critical t-value with 34 degrees of

in the dependent variable. In multiple regression, the F- freedom is 2.03. The prediction interval at the 95%

statistic is used to test whether at least one independent confidence level is:

variable, in a set of independent variables, explains a

significant portion of variation of the dependent 7% +/- (2.03 3.50%) = - 0.105% to 14.105%

variable. The F statistic is calculated as the ratio of the

average regression sum of squares to the average sum This range can be interpreted as, given a forecasted

of the squared errors, value for X of 8%, we can be 95% confident that the

dependent variable Y will be between 0.105% and

X<<

W4L

= Y

14.105%.

W4B <<H

ZYZ

df denominator = n k 1 = n 2 Volume 1, Reading 9.

Sources of uncertianty when using regression model &

Note: F-test is always a one-tailed test. estimated parameters:

In a regression with just one independent variable, the F

statistic is simply the square of the t-statistic i.e. F= t2. F- 1. Uncertainty in Error term.

test is most useful for multiple independent variables 2. Uncertainty in the estimated parameters b0 and b1.

while the t-test is used for one independent variable.

3.8 Limitations of Regression Analysis

NOTE:

When independent variable in a regression model does Regression relations can change over time. This

not explain any variation in the dependent variable, problem is known as Parameter Instability.

then the predicted value of y is equal to mean of y. Thus, If public knows about a relation, this results in no

RSS = 0 and F-statistic is 0.

Reading 9 Correlation and Regression FinQuiz.com

Regression is based on assumptions. When these

assumptions are violated, hypothesis tests and

predictions based on linear regression will be

invalid.

Problems for Reading 9 & FinQuiz

Item-set ID# 15579, 15544 & 11437.

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