Binary Logit and Probit Model

Dr. Mahmood Osman Imam

Professor of Finance
University of Dhaka
In order to examine the joint effects of the relevant variables on IPO firms choices for
flotation methods, a mltivariate analysis is necessary. !he de"endent variable in this
case is discrete# it can take only one of t$o vales, nity or %ero. &stimatin' the model
sin' a linear re'ression is ndesirable for the follo$in' for reasons(
First, the distrbance terms in an O)* re'ression are heteroskedastic
+
, leadin' to
inefficient estimates.
*econd, the conditional ex"ectation of the de"endent variable can lie otside the ,-,+]
ran'e, makin' inter"retation of the conditional ex"ectation as a "robability difficlt
.
.
!hird, "redictions otside the nit interval can be "rodced for vales of x otside the
sam"le ran'e even if the coefficient estimates are derived by maximi%in' the sm of
s/ared residals sbject to the condition that $ithin sam"le, "redictions lie in the
nit interval.
0
Forth, O)* is "articlarly sensitive to model s"ecification error, leadin' to biased
slo"e estimates. !his "roblem arises becase observations in a 'iven sam"le may be
dra$n excessively from attribtes $hose vales are associated $ith extreme vales of
choice "robabilities ,-,+]. !his bias is in reality a form of model s"ecification bias
1
.
!o overcome these "roblems in estimation, a lo'it model is sed to investi'ate the
IPO firms choice of flotation methods in an asymmetric information frame$ork.
2e define an nobserved res"onse variable FM
i
*
$hich is an index of the
"ro"ensity to se the fixed3"rice flotation method in any "articlar "blic offerin'. !he
index FM
i
*
may be inter"reted as reflectin' the "erceived differential benefits to the
issin' firm of em"loyin' fixed "rice and "rice3driven "rocedre in the ith "blic
+
In a O)* model of binary choice, the distrbance ui 'iven xi can take the t$o vales ( $hen yi 4 1
ui = 1 - x
/
i and yi 4 0 ui = - x
/
i and &5ui6 4 51 - x
/
i6 "i 7 5- x
/
i6 5+ 3 "i 6 4 - "i = x
/
i. 8nd
9ar5ui6 4 &5ui
.
6 4 51 - x
/
i6
.
"i 7 5- x
/
i6
.
5+ 3 "i 6 4 51 - x
/
i6
.
x
/
ii 7 5- x
/
i6
.
51 - x
/
i) = (x
/
i) 51 - x
/
i) =
&5yi6,+ 3 &5yi6]. *ince the variance of ui de"ends on i, the ui are heteroskedastic.
.
*ee Maddala 5+::+6, ".+;.
0
*ee Pindyck and <binfeld 5+:=-6, "..1..
1
Ibid., "". .1.3.10.
>Mahmnood Osman Imam
offerin'. 2hen sch benefits of sin' fixed3"rice method are 'reater than those of "rice3
driven method, the "ro"ensity to se the fixed "rice flotation method $ill be 'reater than
%ero# i.e. FM
i
*
> 0. If $e have a set of K ex"lanatory variables x
i+
, x
i.
, x
i0
x
ik
, then the
lo'it model assmes that a relationshi" can be defined by the nderlyin' res"onse
variable FM
i
*
! sch that
FM X u
i j
j
k
ij i i i
* /
+ + +

1
x
?o$ever, the "ro"ensity to se a "articlar method of flotation can not be directly
observed. In the binary choice model $hat $e observe is a dmmy de"endent variable
FM
i
$hich is defined by
[ FM
i

0 otherwise ie Price-driven procedure
1 if FM > 0 ie Fixed Price Offer
i
*
If $e define P
i
as the conditional "robability of observin' FM
i
4 + then
P Prob FM F
i i i i
( ) ( )
/
+ x
$here F is the cmlative distribtion of the error term u. !he lo'it model derives its
name from the distribtional assm"tion made abot the error term u and the cmlative
distribtion is assmed to be @lo'isticA. !hs, in the lo'it model
( )
F
e
e e
i
i
i i
x
/
/
/ /

+

x
x x
1
1
1
In the lo'it model, the odds ratio of an event occrrin' are defined as the ratio of
the "robability that the event $ill occr to the "robability that the event $ill not occr.
8nd the lo'arithm of the odds ratio or logit is an exact linear fnction of the xs. !hat is,
odds ratio
( )
( )
ln ln
/
/
/
P
P
F
F
i
i
i
i
i
1
1

_
,

_
,

x
x
x

logit
*ince the reali%ations of FM
i
are a binomial "rocess, if there are n observations the
likelihood fnction can be $ritten as
( )
[ ]
( ) ( )
L P P F F
i
FM
i
FM
i
n
i
FM
i
i
FM
i i
i

1 1
1
1 1 0
x x
/ /

>Mahmnood Osman Imam
$ith the lo' likelihood
( )
[ ]
( )
( )
[ ] { }
ln ln ln
/ /
L FM F FM F x
i
i
i
i
i
n
+

x 1 1
1
!he likelihood fnction of the lo'it model is 'lobally concave, hence the vector
can be estimated sin' a maximm likelihood a""roach
B
and an a""ro"riate nmerical
al'orithm.
Or fll3scale cross3sectional model takes the form

7 7 7
7
FM IPOUNCER UREPTN IPOSIZE TOBINQ
DEBTD UNI LPSIG UPRES VARTYNOI
DFCF MKTCOND MOLD U
i i i i i
i i i i i
i i i i
*
+ + + +
+ +
+ + +



+ . 0 1
B ; C = :
+- ++ +.
$here is a constant, i re"resents the observation 5IPO firm
i
6,
i
is assmed to be
lo'istically distribted,
k
re"resent the coefficients on the asymmetric information
variables, and the observed de"endent variable is already defined to be + if the IPO firm
i
em"loyed a fixed3"rice flotation method and - other$ise.
"nter#retation and $%aluation o& Logit 'odel
!he follo$in' note shold be taken into consideration $hile inter"retin'
estimated coefficients and evalatin' the lo'it model
&stimated coefficients do not indicate the increase in the "robability of the event
occrrin', 'iven a one3nit increase in the corres"ondin' inde"endent variable.
<ather, the coefficients reflect the effect of a chan'e in an inde"endent variable
on lo'it. In this case, the amont of the increase in "robability de"ends on the
ori'inal "robability and ths on the initial vales of all the inde"endent variables
and their coefficients. *"ecifically,
( )

P
x
e
e
i
ij
j
i
i

x
x
/
/
1
2
$here x
ij
is the jth element of x
i
. ?o$ever, the si'n of the coefficient does
indicate the direction of the chan'e.
B
!he estimation of the lo'it model thro'h maximm likelihood a""roach is 'iven in a""endix30.1.
>Mahmnood Osman Imam
8 test of hy"othesis that ex"lanatory variables, other than an interce"t, have no
im"act on choice "robabilities P
i
, i.e. ?
-
(
.
4
0
4 ... 4
k
4 -, can be carried ot
sin' the likelihood ratio test. !he likelihood ratio test statistic is
( ) ( )

1
]
1

2 2 ln ln ln l l
$here
( ) l

is the vale of the likelihood fnction evalated at the maximm

likelihood estimates and
( ) l

is the maximm vale of the likelihood fnction

nder the hy"othesis that ?
-
(
.
4
0
4 ... 4
k
4 -. If the hy"otheses are tre,
then, asym"totically, the test statistic has a
.
5k3+6
distribtion. 8 related
smmary measre is the McFadden <
.
defined as
( )
( )
R
2
1

ln
ln
l
l

!his measre has vale - $hen ln

( ) l

4 ln
( ) l

i.e. $hen estimated

coefficients are e/al to %ero, and vale + $hen the model is a "erfect "redictor
in the sense that
P F x
i
i

( )
/
1
. !his measre is analo'os to the coefficient
of determination <
.
in linear re'ression model.
>Mahmnood Osman Imam