Spring 2009

ECON102B: Solutions to Problem Set 1

EXERCISE 2.6

(a) The intercept estimate b1 240 is an estimate of the number of sodas sold when the
temperature is 0 degrees Fahrenheit. A common problem when interpreting the estimated
intercept is that we often do not have any data points near X 0. If we have no
observations in the region where temperature is 0, then the estimated relationship may not
be a good approximation to reality in that region. Clearly, it is impossible to sell 240
sodas and so this estimate should not be accepted as a sensible one.

The slope estimate b2 6 is an estimate of the increase in sodas sold when temperature
increases by 1 Fahrenheit degree. This estimate does make sense. One would expect the
number of sodas sold to increase as temperature increases.

(b) If temperature is 80 degrees, the predicted number of sodas sold is

yˆ 240  6 u 80 240

(c) If no sodas are sold, y 0, and

0 240  6 u x or x 40

Thus, she predicts no sodas will be sold below 40qF.

(d) A graph of the estimated regression line:

300

200

100
SODAS

-100

-200

-300
0 20 40 60 80

TEMP

Figure xr2.6 Graph of regression line for soda sales and temperature

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 ECON102B: Solutions to Problem Set 1 Spring 2009

EXERCISE 2.7

(a) Since

Vˆ 2
¦ eˆi2 2.04672
N 2
it follows that

¦ eˆi2 2.04672( N  2) 2.04672 u 49 100.29

(b) The standard error for b2 is

se(b2 ) n
var( b2 ) 0.00098 0.031305

Also,

n Vˆ 2
var(b2 )
¦ ( xi  x )2
Thus,
Vˆ 2 2.04672
¦  xi  x 
2
2088.5
n
var b  0.00098
2

(c) The value b2 0.18 suggests that a 1% increase in the percentage of males 18 years or
older who are high school graduates will lead to an increase of $180 in the mean income
of males who are 18 years or older.

(d) b1 y  b2 x 15.187  0.18 u 69.139 2.742

¦  xi  x  ¦ xi2  N x 2 , we have
2
(e) Since

¦ xi2 ¦  xi  x 
2
 N x2 2088.5  51 u 69.1392 = 245,879

(f) For Arkansas

eˆi yi  yˆi yi  b1  b2 xi 12.274  2.742  0.18 u 58.3 0.962

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 ECON102B: Solutions to Problem Set 1 Spring 2009

EXERCISE 2.8

(a) The EZ estimator can be written as

y2  y1 § 1 · § 1 ·
bEZ
x2  x1
¨ ¸ y2  ¨ ¸ y1 ¦ ki yi
© x2  x1 ¹ © x2  x1 ¹
where
1 1
k1 , k2 , and k3 = k4 = ... = kN = 0
x2  x1 x2  x1

Thus, bEZ is a linear estimator.

(b) Taking expectations yields

ª y  y1 º 1 1
E  bEZ  E« 2 » E  y2   E  y1 
¬ x2  x1 ¼ x2  x1 x2  x1
1 1
E1  E2 x2   E1  E2 x1 
x2  x1 x2  x1

E2 x2 E x § x2 x1 ·
 2 1 E2 ¨  ¸ E2
x2  x1 x2  x1 © x2  x1 x2  x1 ¹
Thus, bEZ is an unbiased estimator.

(c) The variance is given by

var  bEZ  var(¦ ki yi ) ¦ ki2 var  ei  V2 ¦ ki2

§ 1 1 · 2V 2
V2 ¨  ¸
¨ x  x  x  x  ¸
2 2
 x2  x1 
2
© 2 1 2 1 ¹

ª 2V2 º
(d) If ei ~ N  0, V2  , then bEZ ~ N «E2 , »
«¬  x2  x1  »¼
2

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 ECON102B: Solutions to Problem Set 1 Spring 2009

Exercise 2.8 (continued)

(e) To convince E.Z. Stuff that var(b2) < var(bEZ), we need to show that

 x2  x1 
2
2V 2 V2
¦  xi  x 
2
! or that !
 x2  x1  ¦  xi  x 
2 2
2

Consider

 x2  x1  ª¬ x2  x    x1  x  º¼  x2  x    x1  x   2  x2  x  x1  x 
2 2 2 2

2 2 2
Thus, we need to show that
N
2¦  xi  x  !  x2  x    x1  x   2  x2  x  x1  x 
2 2 2

i 1

or that
N
 x1  x    x2  x   2  x2  x  x1  x   2¦  xi  x  ! 0
2 2 2

i 3

or that
N
ª¬ x1  x    x2  x  ¼º  2¦  xi  x  ! 0.
2 2

i 3

This last inequality clearly holds. Thus, bEZ is not as good as the least squares estimator.
Rather than prove the result directly, as we have done above, we could also refer Professor
E.Z. Stuff to the Gauss Markov theorem.

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 ECON102B: Solutions to Problem Set 1 Spring 2009

EXERCISE 2.10

(a) The model is a simple regression model because it can be written as y E1  E2 x  e

where y rj  rf , x rm  rf , E1 D j and E2 E j .

(b)
General General Exxon-
Firm Microsoft IBM Disney
Electric Motors Mobil
b2 Eˆ j 1.430 0.983 1.074 1.268 0.959 0.403

The stocks Microsoft, General Motors and IBM are aggressive with Microsoft being the
most aggressive with a beta value of Eˆ 2 1.430 . General Electric, Disney and Exxon-
Mobil are defensive with Exxon-Mobil being the most defensive since it has a beta value
of Eˆ 2 0.403.

(c)
General General Exxon-
Firm Microsoft IBM Disney
Electric Motors Mobil
b1 = Dˆ j 0.010 0.006 -0.002 0.007 -0.001 0.007

All the estimates of Dˆ j are close to zero and are therefore consistent with finance theory.
In the case of Microsoft, Figure xr2.10 illustrates how close the fitted line is to passing
through the origin.

.5
.4
.3
.2
MSFT-RKFREE

.1
.0
-.1
-.2
-.3
-.4
-.20 -.15 -.10 -.05 .00 .05 .10

MKT-RKFREE

Figure xr2.10 Observations and fitted line for microsoft

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 ECON102B: Solutions to Problem Set 1 Spring 2009

Exercise 2.10 (continued)

(d) The estimates for E j given D j 0 are as follows.

General General Exxon-

Firm Microsoft IBM Disney
Electric Motors Mobil
Eˆ j 1.464 1.003 1.067 1.291 0.956 0.427

The restriction Dj = 0 has led to only small changes in the Eˆ j .

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 ECON102B: Solutions to Problem Set 1 Spring 2009

EXERCISE 2.13

(a)

11

10

5
1990 1995 2000 2005

FIXED_RATE

Figure xr2.13(a) Fixed rate against time

140

120

100

80

60

40

20
90 92 94 96 98 00 02 04

SOLD

Figure xr2.13(b) Houses sold (1000’s ) against time

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 ECON102B: Solutions to Problem Set 1 Spring 2009

Exercise 2.13(a) (continued)

(a)

2400

2000

1600

1200

800

400
90 92 94 96 98 00 02 04

STARTS

Figure xr2.13(c) New privately owned houses started against time

(b) Refer to Figure xr2.13(d).

(c) The estimated model is

n
STARTS 2992.739  194.233FIXED_RATE
The coefficient 194.233 suggests that the number of new privately owned housing starts
decreases by 194,233 for a 1% increase in the 30 year fixed interest rate for home loans.
The intercept suggests that when the 30 year fixed interest rate is 0%, 2,992,739 will be
started. Caution should be exercise with this interpretation, however, because it is beyond
the range of the data.
Figure xr2.13(d) shows us where the fitted line lies among the data points. The fitted line
appears to go evenly through the centre of data and the residuals appear be of relatively
equal magnitude as we move along the fitted line.

2400

2000

1600
STARTS

1200

800

400
5 6 7 8 9 10 11

FIXED_RATE

Figure xr2.13 (d) Fitted line and observations for housing starts against the fixed rate

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 ECON102B: Solutions to Problem Set 1 Spring 2009

Exercise 2.13 (continued)

(d) Refer to Figure xr2.13(e).

(e) The estimated model is

n 167.548  13.034 FIXED_RATE

SOLD

The coefficient 13.034 suggests that a 1% increase in the 30 year fixed interest rate for
home loans is associated with a decrease of around 13,034 houses sold. The intercept
suggests that when the 30 year fixed interest rate is 0%, 167,548 houses will be sold over a
period of 1 month. Caution should be exercise with this interpretation, however, because it
is beyond the range of the data.

140

120

100
SOLD

80

60

40

20
5 6 7 8 9 10 11

FIXED_RATE

Figure xr2.13(e) Fitted line and observations for houses sold against fixed rate

Figure xr2.13(e) shows us where the fitted line lies amongst the data points. From this
figure we can see that the data appear slightly convex relative to the fitted line suggesting
that a different functional form might be suitable. A plot of the residuals against the fixed
rate might shed more light oin this question. We can see also that the residuals appear to
have a constant distribution over the majority of fixed rates.

(f) Using the model estimated in part (c), the predicted number of monthly housing starts for
FIXED _ RATE 6 is

 STARTS 
n u 1000  2992.739  194.233 u 6  u 1000 1827.34 u 1000 1,827,340

There will be 1,827,340 new privately owned houses started at a 30 year fixed interest rate
of 6%. This is a seasonally adjusted annual rate. On a monthly basis we estimate 155,278
starts.

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 ECON102B: Solutions to Problem Set 1 Spring 2009

EXERCISE 3.7

(a) We set up the hypotheses H 0 : E j 1 versus H1 : E j z 1 . The economic relevance of this

test is to test whether the return on the firm’s stock is risky relative to the market portfolio.
Each beta measures the volatility of the stock relative to the market portfolio and volatility
is often used to measure risk. A beta value of one indicates that the stock’s volatility is the
same as that of the market portfolio. The test statistic given H0 is true, is

bj 1
t ~ t118
se  b j 

The rejection region is t  1.980 and t ! 1.980 , where t(0.975,118) 1.980 .

The results for each company are given in the following table:

Stock t-value Decision rule

0.9593  1
Disney t 0.287 Since 1.98  t  1.98 , fail to reject H 0
0.1420
0.9830  1
GE t 0.162 Since 1.98  t  1.98 , fail to reject H 0
0.1047
1.0744  1
GM t 0.478 Since 1.98  t  1.98 , fail to reject H 0
0.1558
1.2683  1
IBM t 1.726 Since 1.98  t  1.98 , fail to reject H 0
0.1554
1.4299  1
Microsoft t 2.284 Since t ! 1.98 , reject H 0
0.1882
0.4030  1
Mobil-Exxon t 7.256 Since t  1.98 , reject H 0
0.08228

For Disney, GE, GM and IBM, we failed to reject the null hypothesis, indicating that the
sample data are consistent with the conjecture that the Disney, GE, GM and IBM stocks
have the same volatility as the market portfolio. For Microsoft and Mobil-Exxon, we
rejected the null hypothesis, and concluded that these two stocks do not have the same
volatility as the market portfolio.

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 ECON102B: Solutions to Problem Set 1 Spring 2009

Exercise 3.7 (continued)

(b) We set up the hypotheses H 0 : E j t 1 versus H1 : E j  1 . The relevant test statistic, given
H0 is true, is
bj 1
t ~ t118
se  b j 

The rejection region is t < 1.658 where tc t(0.05,118) 1.658 . The value of the test
statistic is
0.4030  1
t 7.256
0.08228
Since t = 7.256 < tc = 1.658, we reject H0 and conclude that Mobil-Exxon’s beta is less
than 1. A beta equal to 1 suggests a stock's variation is the same as the market variation. A
beta less than 1 implies the stock is less volatile than the market; it is a defensive stock.

(c) We set up the hypotheses H 0 : E j d 1 versus H1 : E j ! 1 . The relevant test statistic, given
H0 is true, is
bj 1
t ~ t118
se  b j 

The rejection region is t > 1.658 where tc t(0.95,118) 1.658 . The value of the test statistic
is
1.4299  1
t 2.284
0.1882
Since t = 2.284 > tc = 1.658, we reject H0 and conclude that Microsoft’s beta is greater
than 1. A beta equal to 1 suggests a stock's variation is the same as the market variation. A
beta greater than 1 implies the stock is more volatile than the market; it is an aggressive
stock.

(d) A 95% interval estimator for Microsoft’s beta is b j r t(0.975,118) u se(b j ) . Using our sample
of data the corresponding interval estimate is
1.4299 r 1.980 u 0.1882 = (1.057, 1.803)
Thus we estimate, with 95% confidence, that Microsoft’s beta falls in the interval 1.057 to
1.803. It is possible that Microsoft’s beta falls outside this interval, but we would be
surprised if it did, because the procedure we used to create the interval works 95% of the
time. The problem with the interval estimate is that it is wide. We feel sure that Microsoft
is more volatile than the market, but how much more is not known precisely.

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 ECON102B: Solutions to Problem Set 1 Spring 2009

Exercise 3.7 (continued)

(e) The two hypotheses are H0: D j = 0 versus H1: D j z 0. The test statistic, given H0 is true, is

aj
t ~ t118
se  a j 

The rejection region is t  1.980 and t ! 1.980 , where t(0.975,118) 1.980 .

The results for each company are given in the following table:

Stock t-value Decision rule

0.0010
Disney t 0.152 Since 1.98  t  1.98 , fail to reject H 0
0.0067
0.0059
GE t 1.199 Since 1.98  t  1.98 , fail to reject H 0
0.0049
0.0023
GM t 0.317 Since 1.98  t  1.98 , fail to reject H 0
0.0073
0.0068
IBM t 0.940 Since 1.98  t  1.98 , fail to reject H 0
0.0073
0.0102
Microsoft t 1.156 Since 1.98  t  1.98 , fail to reject H 0
0.0088
0.0073
Mobil-Exxon t 1.904 Since 1.98  t  1.98 , fail to reject H 0
0.0039

We do not reject the null hypothesis for any of the stocks. This indicates that the sample
data is consistent with the conjecture from economic theory that the intercept term equals
0.

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 ECON102B: Solutions to Problem Set 1 Spring 2009

EXERCISE 3.8

(a) We set up the hypotheses H0: E2 = 0 versus H1: E2 < 0. The alternative E2 < 0 is chosen
because an inverse relationship is one where the dependent variable increases as the
independent variable decreases, and visa versa. Thus, a negative E2 suggests an inverse
relationship between variables. The test statistic, given H0 is true, is
b2
t ~ t(182)
se(b2 )

The rejection region is t  t(0.05,182) 1.653 . The value of the test statistic is

194.233
t 19.031
10.2061
Since t = 19.03 < 1.653, we reject the null hypothesis that E2 0 and accept the
alternative that E2  0 . We conclude that there is a statistically significant inverse
relationship between the number of house starts and the 30-year fixed interest rate.

(b) We set up the hypotheses H 0 : E2 150 versus H1 : E2 z 150 . The test statistic, given
H0 is true, is
b2  E2
t ~ t(182)
se(b2 )

The rejection region is t  1.973 and t ! 1.973 , with t(0.975,182) 1.973 . The value of the
test statistic is
194.233  150
t 4.334
10.2061
Since t = 4.334 < 1.973, we reject the null hypothesis E2 150 and accept the
alternative that E2 z 150 . The data indicate that, if the 30-year fixed interest rate
increases by 1%, house starts will not fall by 150,000.

(c) A 95% interval estimate of the slope from the regression estimated in part (a) is:
194.233 r 1.973 u 10.2061 (214.4, 174.1)
This interval estimate suggests that, with 95% confidence, an increase in the 30-year fixed
interest rate by 1% will result in a drop in house starts of between 174,100 to 214,400
houses. We would be surprised if the true value of E2 did not lie in this interval.
In part (b) we tested, at a 5% level of significance, whether E2 = 150 , and we came to the
conclusion that E2 z 150 . This conclusion is consistent with our interval estimate
because at a 95% level of confidence,  150 lies outside the interval. Remember the
relationship between confidence intervals and hypothesis testing: At a 1 D  level of
confidence and an D level of significance, we will not reject a null hypothesis for a
hypothesized value if it falls inside the confidence interval.

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 ECON102B: Solutions to Problem Set 1 Spring 2009

EXERCISE 4.7

(a) ŷ0 b2 x0

(b) Using the solution from Exercise 2.4 part (f)

¦ eˆi2 (2.06592  2.13192  1.19782   0.7363

2
SSE
  0.6703   0.6044 
2 2
11.6044

¦ yi2 42  62  7 2  7 2  92  112 352

11.6044
Ru2 1  0.967
352

   y  y º¼
2
Vˆ 2yyˆ ª ¦ yˆi  yˆ
¬ i (42.549) 2
(c) r 2
0.943
¦  y  y  ¦  yˆ  yˆ 
yyˆ
Vˆ Vˆ
2
y
2
yˆ
2 2
65.461 u 29.333
i i

The two alternative goodness of fit measures Ru2 and ryy2ˆ are not equal.

(d) SST 29.333, SSR 67.370

^SSR  SSE 67.370  11.6044 78.974` z ^SST 29.333`

The decomposition does not hold.

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 ECON102B: Solutions to Problem Set 1 Spring 2009

EXERCISE 4.12

(a) Estimated regression:

n
STARTS 2992.739  194.2334 u FIXED_RATE0
0

In May 2005: n
STARTS 2992.739  194.2334 u 6.00 1827

In June 2005: n
STARTS 2992.739  194.2334 u 5.82 1862

(b) Prediction error for May 2005:

f n
STARTS0  STARTS 2041  1827 214
0

Prediction error for June 2005:

f n
STARTS0  STARTS 2065  1862 203
0

(c) Prediction interval for May 2005:

n rt
STARTS 0 (0.975,182) u se( f ) 1827 r 1.973 u 159.58 (1512, 2142)

Prediction interval for June 2005:

n rt
STARTS 0 (0.975,182) u se( f ) 1862 r 1.973 u 159.785 (1547, 2177)

Both prediction intervals contained the true values.

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