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ECONOMETRICS
Course Work
Malvin Moyo | Sean Anderson |Dominic calus | Mihajlo Tomic | Mohamed Selim Sta
11/10/2010
Table of Contents
1 Question 1 ............................................................................................................................................. 2
2 Question 2: ............................................................................................................................................ 5
3 Question 3 ............................................................................................................................................. 7
4 Question 4 ........................................................................................................................................... 10
5 Question 5 ........................................................................................................................................... 10
6 Question 6 ........................................................................................................................................... 11
7 Question 7 ........................................................................................................................................... 12
1
1 Question 1
ii.
The following are the graphs illustrating the evolution over time of the explanatory variables that we
are going to use during this analysis:
Term spread FX
5 2.1
4 2.0
3 1.9
2 1.8
1 1.7
0 1.6
-1 1.5
-2 1.4
01 02 03 04 05 06 07 08 09 10 01 02 03 04 05 06 07 08 09 10
OIL
140
120
100
80
60
40
20
01 02 03 04 05 06 07 08 09 10
It is clear from the graphs above that the financial time series are not stationary. In order to
transform those to stationary series we take the logarithmic difference.
2
Term Spread Return Graph
25 FTSE_RET
.10
20
15 .05
10
.00
5
-.05
0
-.10
-5
-10 -.15
01 02 03 04 05 06 07 08 09 10 01 02 03 04 05 06 07 08 09 10
.2
.08
.1
.04
.0
.00 -.1
-.2
-.04
-.3
-.08
-.4
-.12 -.5
01 02 03 04 05 06 07 08 09 10 01 02 03 04 05 06 07 08 09 10
A common pattern in the 4 graphs above is the 2007-2008 financial meltdowns that inflicted a great
deal of damage to the stationarity of financial time series.
After running the augmented dickey fuller test we can observe that only the term spread variable is
not stationary over time. The result of the test is shown below.
t-Statistic Prob.*
3
Date: 11/23/10 Time: 05:58
Sample (adjusted): 2001M03 2010M10
Included observations: 116 after adjustments
iii.
In order to observe distributional properties of the portfolio and market excess returns, we carried out a
16
Series: Portfolio excess return
14 Sample 2000M10 2010M10
Observations 120
12
Mean 0.005759
10 Median 0.011285
Maximum 0.101791
8 Minimum -0.196917
Std. Dev. 0.049575
6 Skewness -0.878741
Kurtosis 4.652985
4
Jarque-Bera 29.10550
2 Probability 0.000000
0
-0.20 -0.15 -0.10 -0.05 0.00 0.05 0.10
Figure 2
As we can observe, the mean and median are not equal and the p-value is less than the critical 5% value, thus we
do not assume that the distribution is normally distributed. As the skewness is -0.878741 and the kurtosis is
greater than 3, the distribution is negatively skewed, confirming non-normality. To check this, we also observe
that the Jarque-Bera is not too high and significant at the 1% level, thus we can suggest the distribution is not
normal.
4
20
Series:Port Excess Return
Sample 2000M10 2010M10
16 Observations 120
Mean -0.001052
12 Median 0.006456
Maximum 0.083000
Minimum -0.139546
8 Std. Dev. 0.044360
Skewness -0.738131
Kurtosis 3.549304
4
Jarque-Bera 12.40542
Probability 0.002024
0
-0.10 -0.05 -0.00 0.05
Figure 3
Figure 3 shows the Market (FTSE 100) Excess Returns distribution. In similar fashion to our observation for the
portfolio excess return, the mean and median are not equal and the p-value is less than the critical 5% level. The
higher the Jarque-Bera, the more normal the distribution and it is not so high. In addition, the Kurtosis is also
greater than 3, which shows that the distribution is not normal, but negatively skewed. The Jarque-Bera statistic
is insignificant at any level.
These observations are not surprising as research study suggests that return series data are not normally
distributed.
2 Question 2:
Dependent Variable: PORT_RET
Method: Least Squares
Date: 11/23/10 Time: 06:24
Sample (adjusted): 2000M11 2010M10
Included observations: 120 after adjustments
Examination of the R-squared and the adjusted R-squared values suggests that a good proportion of the variability
of excess returns in the portfolio is explained by the independent variables, at approximately 80% level. As the p-
5
values for the Market Excess Returns (FTSE_RET) and Brent Crude Oil returns (OIL_RET) are less than the
critical 5% level, it suggest they are the insignificant terms in the regression and the null hypothesis for
transformed FTSE_RET and OIL_RET into unexpected changes would be rejected. The intercept, and returns
on the FX and TS suggests these are the significant and our assumption is made on the 1% critical value test.
The Durbin-Watson statistic result, which is a measure of autocorrelation of the first order, is around 2, which
shows that there is no evidence of positive or negative serial correlation. The coefficient estimate of 0.953420 for
the excess returns of the FTSE 100 means that if the previous increases by one unit, the dependent variable will
be expected to increase by 0.953420, everything else being equal. With a S.E. of regression of 0.022231, we can
assume certainty of our model, as the values of our coefficients are accurate without much variation and as the fit
of the line to the actual data is close, with the error terms concentrated around the line.
After we identified the insignificant variables as Excess Returns on the FTSE 100 and the Brent Crude Oil
Returns, we dropped both variables from the model and run a new model. As can be seen from our output, our
regression output for the model actually got worse. The R2 decreased drastically .However, the DW statistic is
still around 2 and the p-value now significant at the 10% level.
Wald Test
The Wald statistic is a measurement of how close the unrestricted estimates come to satisfying the restrictions
under the Ho: null hypothesis. We want to check if our β is statistically different from 1. If the restrictions are
indeed true, then the unrestricted estimates should come close to satisfying the restrictions. WE will use the Chi-
square version of the test as we have a large sample size. The p-value of 0 indicates that the β of our portfolio
(PER) is statistically significantly different from 1.
6
Wald Test:
Equation: EQ02
3 Question 3
Residuals Normality Test
20
Series: RESID
Sample 2000M10 2010M10
16 Observations 120
Mean 2.33e-18
12 Median 0.003456
Maximum 0.095444
Minimum -0.199436
8 Std. Dev. 0.048599
Skewness -0.872480
Kurtosis 4.661271
4
Jarque-Bera 29.02354
Probability 0.000000
0
-0.20 -0.15 -0.10 -0.05 0.00 0.05 0.10
Histogram Normality test, check for normality of the residuals series. If the distribution is normal, then the mean
and median should be observed as more or less equal. Also, the distribution should not be skewed and as such
have a coefficient of Kurtosis of 3. The shape of the histogram should be observed as bell-shaped and the Jarque-
Bera stat should be high, in other words not significant. In the case of our observations, the kurtosis is higher than
3, suggesting that our series is negatively skewed. The p-value is less than the critical at the 1% level, thus we
would reject the null H0: normality. However, as our sample size is sufficiently large, we can ignore this rule, as
the violation of normality in this instance would be insignificant. According to the theory of central limit, as the
distribution sample gets sufficiently larger, the statistics observed will follow the appropriate distributions, even
if the error distribution is not normal.
Multicollinearity Test
7
FTSE_RET OIL_RET TS_RET FX_RET
FTSE_RET 1.000000
OIL_RET 0.204845 1.000000
TS_RET -0.193507 -0.103390 1.000000
FX_RET 0.050633 0.359992 0.064105 1.000000
A very good method of testing the extent of Multicollinearity is by looking at the matrix of correlations between
the independent variables. Our model involves correlation relationships between 4 variables and we can observe
that there is no high positive or negative correlation between the variables. We can thus say that Multicollinearity
does exist, because the correlation between went as high as 36%. (FX variable and Crude Oil)
Hetroskedasticity Test
Test Equation:
Dependent Variable: RESID^2
Method: Least Squares
Date: 11/23/10 Time: 07:29
Sample: 2000M11 2010M10
Included observations: 120
The White's test is a test of the null hypothesis H0: no Hetroskedasticity against Hetroskedasticity of some
unknown general form, in other words that there is homoscedasticity. In EViews, the test statistic is computed by
8
an auxiliary regression, where we regress the squared residuals on all possible (non-redundant) cross products of
the regression. In this instance, we reject the null hypothesis of no Hetroskedasticity at the 1% significance level
because we obtain a p-value of 0.466760, which is more than the critical. As such, we can assume that there is no
evidence of Hetroskedasticity, meaning the variation of the errors is not constant. The absence of
Hetroskedasticity in our model means we can use an OLS model, hence, any inference and conclusions made
could be assumed to be correct.
Bellow you can observe a scatter plot of the error terms. It is clear that there is no trend in the graph which
confirms the absence of Hetroskedasticity.
RESID
.08
.06
.04
.02
.00
-.02
-.04
-.06
-.08
01 02 03 04 05 06 07 08 09 10
Autocorrelation Test
Breusch-Godfrey Serial Correlation LM Test:
Test Equation:
Dependent Variable: RESID
Method: Least Squares
Date: 11/23/10 Time: 07:40
Sample: 2000M11 2010M10
Included observations: 120
Presample missing value lagged residuals set to zero.
9
S.E. of regression 0.021816 Akaike info criterion -4.704861
Sum squared resid 0.054735 Schwarz criterion -4.495799
Log likelihood 291.2916 Hannan-Quinn criter. -4.619960
F-statistic 0.550893 Durbin-Watson stat 1.979638
Prob(F-statistic) 0.815755
The Breusch-Godfrey autocorrelation test was carried out to test for serial correlation for higher order ARMA
errors. The serial correlation test is carried out to analyze whether the errors are statistically independent and
uncorrelated of each other. The null hypothesis assumes that there is no serial correlation of independent
variables and if this assumption is broken, the OLS is again biased, giving misleading values. After conducting the
Breusch-Godfrey test, we got a p-value of 0.815755 and thus came to the conclusion to not reject the null
hypothesis at 5% significance level. We used 4 lags and as such, under the null hypothesis the current error is not
related to any of its other 4 previous values. Due to the evidence of no autocorrelation, there is no need for
remedy.
4 Question 4
Whilst carrying out our diagnostic tests, we encountered only few problems such as a partial multicolinearity
between two of our variables.
We have explored different independent variable combinations and have witnessed better error term normality
when introducing two dummy variables. The first takes the value 1 at the .com bubble in 2000 and the second
shadows the financial crisis of July 2007. Also, omitting the Crude oil independent variable has shown to be
beneficial for the normality of the error terms. Below is the histogram graph:
20
Series: Residuals
Sample 2000M11 2010M10
16 Observations 120
Mean 9.54e-19
12 Median -0.001188
Maximum 0.067206
Minimum -0.065667
8 Std. Dev. 0.022823
Skewness 0.441043
Kurtosis 3.961133
4
Jarque-Bera 8.509269
Probability 0.014198
0
-0.050 -0.025 -0.000 0.025 0.050
The P-statistic increased dramatically from 0.6% to 1.4% in the residual normality test which is a sign that our
remedy had improved the model.
5 Question 5
Dependent Variable: PORT_RET
Method: Least Squares
Date: 11/23/10 Time: 12:51
Sample (adjusted): 2000M11 2010M10
Included observations: 120 after adjustments
10
FXSQ 3.396208 3.501980 0.969797 0.3342
FTSESQ -7.889109 1.279905 -6.163822 0.0000
We augmented our model by including the squares of the factor shocks, which do not take the direction into
account, as the squared number will always be positive. By squaring it, we found the magnitude of the factor
shocks and not the direction of the movement.
By continuing our augmentation of the model, we indeed found our model not to improve, when we excluded
some of the variables. As such, we decided that the model which gave us the best statistics at this point was with
independent variables; squared FTSE100 returns, squared crude oil log return, squared GBP/Dollar log return
and squared term spread.
Chow Breakpoint Test
6 Question 6
.2
.1
.0
.10 -.1
.05 -.2
.00
-.05
-.10
01 02 03 04 05 06 07 08 09 10
From the residuals graph above it can be seen that there are several significant outliers within the range from
2007 until 2008. In order to test for breakpoints we are going to run a Chow breakpoint test and decided to
choose September 2007 and December 2008 as breakpoints.
11
The results of the test show us that the chosen breakpoints are significant at the 5% significance level. Therefore,
we reject the null hypothesis of no breakpoints and conclude that some events caused fluctuations within our
portfolio returns. The conclusion is that we need to add dummy variables into the model and check if our model
will improve.
The model above includes a dummy variable for the period from September 1998 until the end of the series. As
we can see our model improved slightly, as the R2 and the Adjusted R2 increased above 0.84, a value that is
already considered as an excellent goodness of fit.
7 Question 7
Although we are fully aware that this is not a perfect model, as for instance the Durbin-Watson statistic is
worrying, we believe that this model is able to predict excess returns.
By implementing a second order integration and a dummy variable we have succeeded to bring the residual to a
near normality status as the below graph can show:
12
20
Series: Residuals
Sample 2000M11 2010M10
16 Observations 120
Mean 0.004542
12 Median 0.002523
Maximum 0.065961
Minimum -0.061159
8 Std. Dev. 0.022027
Skewness 0.339612
Kurtosis 3.946519
4
Jarque-Bera 6.786217
Probability 0.033604
0
-0.06 -0.04 -0.02 -0.00 0.02 0.04 0.06
Skewness is closer to zero and kurtosis is the closest we could get to 3. Another factor that informs us on the
quality of the model is the AIC and BIC criterions. In fact we have managed to decrease the criterions throughout
the models.
13