40
35
Excess return on fund XXX
30
25
20
15
10
0
0 5 10 15 20 25
Excess return on market portfolio
x
c Chris Brooks 2013
‘Introductory Econometrics for Finance’
10
Ordinary Least Squares
yt
ût
ˆyt
xt x
P5
• So min. uˆ1 2 + uˆ2 2 + uˆ3 2 + uˆ4 2 + uˆ5 2 , or minimise t=1 uˆt
2
.
This is known as the residual sum of squares.
• But what was uˆt ? It was the difference between the actual
point and the line, yt − yˆt .
P 2
(yt − yˆt )2 is equivalent to minimising
P
• So minimising uˆt
with respect to α̂ and β̂.
T
X T
X
2
L= (yt − ŷt ) = (yt − α̂ − β̂xt )2 .
t=1 t=1
∂L X
= −2 (yt − α̂ − β̂xt ) = 0 (1)
∂ α̂ t
∂L X
= −2 xt (yt − α̂ − β̂xt ) = 0 (2)
∂ β̂ t
• So we can write
• From (3),
α̂ = ȳ − β̂x̄ (5)
• So overall we have
X
xt yt − T xy
β̂ = X and α̂ = ȳ − β̂x̄
xt2 − T x̄ 2
0 x
c Chris Brooks 2013
‘Introductory Econometrics for Finance’
19
The Population and the Sample
• Additional assumption
• Unbiased
• Efficiency
_ _
y y
_ _
0 x x
0 x x
• Calculations
• There are two ways to conduct a hypothesis test: via the test
of significance approach or via the confidence interval
approach.
f ( x)
f ( x)
• You should all be familiar with the normal distribution and its
characteristic “bell” shape.
f ( x)
normal distribution
t-distribution
–2.086 +2.086 x
H0 : β = 2
vs. H1 : β =
6 2
β̂ − β ∗
test stat =
SE (β̂)
0.5091 − 1
= = −1.917
0.2561
as above. The only thing that changes is the critical t-value.
c Chris Brooks 2013
‘Introductory Econometrics for Finance’
59
Changing the Size of the Test: The New Rejection
Regions
H0 is true H is false
√0
Significant Type I error = α
Result of test (reject H0 )
√
Insignificant Type II error = β
(do not reject H0 )
If the test is H0 : βi = 0
•
H1 : βi 6= 0
i.e. a test that the population coefficient is zero against a
two-sided alternative, this is known as a t-ratio test:
β̂i
Since βi∗ = 0, test stat =
SE (β̂i )
• Do we reject H0 : β1 = 0? (No)
H0 : β2 = 0? (Yes)
xt
• The model: Rjt − Rft = αj + βj (Rmt − Rft ) + ujt for j=1, ...,
115
35
30 28
Frequency
25
21
20
15
15
10
5
5 2 2
1
0
–5 –4 –3 –2 –1 0 1 2 3
t-ratio
25
Frequency
20
15
10 10
10
5 3
1 1
0
–5 –4 –3 –2 –1 0 1 2 3
t-ratio
• 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.
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.
Data:
Monthly UK stock returns from January 1955 to 1990 on all
firms traded on the London Stock exchange.
• Calculate the average monthly return for the stock i over the
first 12, 24, or 36 month period:
R̄i = n1 nt=1 Uit
P
• If n = 1year:
Estimate for year 1
Monitor portfolios for year 2
Estimate for year 3
...
Monitor portfolios for year 36
Comments
• Small samples