QBA25622 ASSIGNMENT PROJECT

Discipline of Finance, UTS.

Semester 1, 2016.
Subject Coordinator: Dr Otto Konstandatos
This assignment has several parts of unequal value. Some parts are technical, and are designed to help
you understand the connection between Mathematics and Econometric Regression Analysis.
You must type or neatly hand-write such answers in the spaces provided.
Other parts are applied, and are designed to help you develop practical econometric skills. You will
apply regression analysis as done by finance professionals using real world data. These parts will test
your econometric modelling skills using multiple regression and Eviews.
For these parts you may be required to report your Eviews output in the spaces below.
You must include this cover sheet. This assignment can be done in groups of up to six (6) students. Your
group members do not need to be part of the same tutorial group, but you should nominate the tutor for
the majority of your group members in the space below.
No names may be added to the group lists apart from the names that appear below at hand-in.
Submit only one assignment for each group. DO NOT hand in a separate assignment for each group
member.
Late assignments will require a Special Consideration application and will otherwise not be accepted.

Due Time/Date/Venue: The assignment submission boxes are located on Level 5, Building 8
(Chau Chak Wing Building) in the Business Faculty. They are used by many subjects so its
important to identify your assignment CLEARLY with your names and SIDs. Do not remove
this assignment cover. The onus is in you to submit your assignment into the correct box by the due
date. The deadline to submit your assignment is

12:00pm Wednesday 1 June, box labelled FINANCE 4

Name

Late assignments will require special consideration to avoid a late penalty.

Student Number

Date stamp or tutors signature and date

Group Work Protocol

The following group work protocol is required to satisfy the by-laws on assessment tasks
of the Faculty of Business at UTS.
Group work and group assignments are an important part of business education. The
purpose of group work goes beyond the requirements of the group project itself. Group
work is also intended to develop awareness of the dynamics of teamwork and your role in
a team environment. In undertaking group work it is expected that each team member
will communicate with other team members in a professional and courteous manner.
Resolving any conflict or difficulties that arise within the team is also part of the group
dynamics that may emerge during the project. It is expected that each team member will
take responsibility for managing and reducing any conflict that may arise. After group
membership is decided, you must clearly communicate any dissatisfaction with a group
member for non-contribution (or other reasons) directly to them before any decision to
eject the group member is taken by the other members. If the team members are unable to
resolve tensions or conflicts then this MUST be discussed with the lecturer/tutor as soon
as it becomes obvious that a resolution within the team cannot be agreed.
In the learning environment of group work we are seeking to ensure that you develop and
demonstrate both academic skills and important group work skills such as:

Commitment to working with others (eg, undertaking a fair share of the work,
sharing ideas, doing the tasks allocated, attending meetings)

Collaboration and inclusiveness (eg encouraging and supporting others, respecting

others; recognising the skills and valuing the contribution of others, helping
resolve conflicts)

Contribution to establishing and working towards a common outcome (eg

establishing and supporting team goals, plans, rules, roles, decisions)

Group Work Declaration Form

Individuals must sign a declaration form, otherwise the project report will not be
marked. Complete only Part 1 or Part 2. Do not complete both. This sheet should be
completed and handed in along with your group assignment.
Part 1
I believe that all members of the group have contributed fairly to this assignment, and each member should
receive the same mark for the assignment.
Group leader:.............................................................................Signature.........................................................

Group member names:

Part 2
I believe that not all members of the group have contributed fairly to this assignment. I believe the
proportion of the total workload that each has contributed is indicated below.
Your name..........................................................................Signature...........................................................

Group member names:

Proportion of Workload:

..%

..%

..%

..%

..%

..%

Total = 100%
Please note that if you have signed Part 2 you must attach a statement explaining:

Why you believe a group member/group members have not contributed their fair share to
the project
A breakdown of tasks you and others have completed in the project
An estimate of the time you think each of those tasks has taken.
Any other positive or negative contributions made by you and others

This information will be shown to other group members so that they have an opportunity
to respond.

While each group members comments will be taken into consideration, the final
decision on how the marks are awarded will remain the right of the course
coordinator.

Background.
The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate
required rate of return of an asset, where that asset is to be added to an already well-diversified
portfolio, given that asset's non-diversifiable risk. Traditionally, applications of the CAPM use only
one variable to describe the returns of a portfolio or stock with the returns of the market as a whole:
r stock r f = stock + stock ( r mr f ) +u t

(1)

In contrast, the FamaFrench model uses three variables:

r stock r f = stock + stock ( r mr f ) + 2 SMB + 3 HML+ut

(2)

r stock is the stocks rate of return, r f is the risk-free return rate, and r m is the return of the
whole stock market. The parameter stock is the stocks alpha. It measures how much the stock
outperforms its theoretical predicted returns under the CAPM and stock is the stocks beta, which
measures the stocks exposure to the overall market. Different stocks will have different parameters.
The Fama-French model contains two additional factors to explain stock returns. SMB "Small
market capitalization Minus Big "; measures the historic excess returns of small cap stocks over big
caps. HML High book-to-market ratio (BtM) Minus Low book-to-market ratio measures the
historic excess returns of value stocks (small BtM ratio) over growth stocks (High BtM ratio). These
factors are calculated with combinations of portfolios composed by ranked stocks (BtM ranking,
Capitalisation ranking) and available historical market data. Historical values are available on
Kenneth French's web page for American stocks.
We have supplied real Australian data from the ASX in the spreadsheet AssgtData.xlsx. The variables
are defined as follows:
r BHP

= Monthly return on BHP stock as observed on the ASX.

r m = Monthly return on market index, here the All Ordinaries Index, AOI.
SMB

= Small market capitalization Minus Big market capitalization factor.

HML = High book-to-market ratio Minus Low book-to-market ratio

You are to assume a risk-free rate of r f =0.005 per month. Your task is to estimate the FamaFrench three factor model using the given data, and to determine whether it is any better at explaining
the BHP stock returns compared to the market excess returns given by the All Ordinaries Index.

Please enter all your answers into the provided spaces below.
Part 1: Deriving the Least Squares Estimators
Recall, in Linear Least Squares, we have to estimate the line of best fit which minimizes
the sum of squared deviations of the data. This is equivalent to choosing parameters
(b0 , b1 ) which minimises the function of two variables (namely SSR):
n

SSR f (b0 , b1 ) ( y i b0 b1 xi ) 2
i 1

You will use calculus to show that f (b0 , b1 ) is minimized for the choices:
n

(x

b1 1

i 1

x )( y i y )
,

(x
i 1
n

x)2

b0 0 y b1 x

1
1
xi
y yi

n i 1
n i 1 .
where
and
Revise the online videos explaining the Rules of Summation for the Week 5 lecture,
particularly for the summation properties described below. You may assume the following
summation properties in your assignment solution:
x

If k is a constant,

k nk
i 1

.
n

(aui bvi ) a u i b vi

i 1
i 1
Given u i and vi for i 1 n , then i 1
.
Differentiating a summation (the derivative of the sums equals the sum of the
derivatives):
n
n
f i ( x, y )
f i ( x, y )
n
n
f
(
x
,
y
)

and
f
(
x
,
y
)

i
i
x i 1
x
y i 1
y
i 1
i 1
n

( xi x ) 0
Q1 (2 mark): The total deviation about the mean is always zero, i.e. i 1
.
Expand the summation across the brackets and apply this fact to the y i to prove that:
n

( x i x )( y i y )
i 1

Ans:

x (y
i 1

y)

x
x
x i ( ix )
n

Q2 (1 mark) Prove that ( ix )2 =

i=1

i=1

Ans:

f (b0 , b1 ) 0

b
0
Q3 (2 marks): By differentiating the summation, show that
when

b0 0 y b1 x
.

Ans:

Q4 (2 marks): Differentiate the summation with respect to b1 to get a summation

f (b0 , b1 )
expression for b1
.

Ans:

Q5 (4 marks): Prove that by choosing b0 and b1 to minimize

obtain the least squares estimators, namely:
n

b1 1

(x
i 1

(x
i 1

Ans:

x )( y i y )
i

x)

(y

b0 b1 xi ) 2

i 1

b0 0 y b1 x

you

Q6. (1 marks): Read the supplied data into Eviews. Generate two new variables rBHP rf and
r
, which are the stock and marketexcess returns respectively, assuming r f =0.005 . Use
r f
these to estimate the model given by Equation (1):
r
r BHP r f =B 0+ B 1( mr f )+ut

Paste your Eviews output below

Ans:
Dependent Variable: RBHP
Method: Least Squares
Date: 05/29/16 Time: 12:46
Sample: 1 46
Included observations: 46
Variable

Coefficient

Std. Error

t-Statistic

Prob.

C
RM

0.004952
1.081692

0.008298
0.158374

0.596735
6.829999

0.5537
0.0000

R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
Prob(F-statistic)

0.514611
0.503579
0.054784
0.132058
69.35149
46.64888
0.000000

Mean dependent var

S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat

-0.008037
0.077755
-2.928325
-2.848819
-2.898542
2.158674

Y=0+1(rm-rf)+ut
RBHP = 0.004952 + 1.081692RM
SE =
(0.008298) (0.158374)
Q7. (1 mark) Comment on the sign of the estimated coefficient B 1 , and state whether this is what
you expect.
Ans:

The coefficient for RM, which represents the monthly return on market index, has a value of 1.081692.
It has a positive sign, which indicates as monthly return on market index increases, the monthly return
on BHP stock will increase. This is expected as an increase in return on the market index will result in
an increase in return on BHP stock.

Q8 (2 marks) Formulate and carry out an appropriate hypothesis test, to test whether the excess
market returns explain the excess returns of BHP shares. Use the t-statistic approach, at the =0.05
level. Assume the large sample approximation applies.
Ans:
To test if market returns explains the excess returns of BHP shares, RM 0
H0: RBHP=0
H1: RBHP0
This is a two tailed test, so 2.5% each tail, tcrit = 1.96.
If p-value<0.05, accept H1 at =0.05.
^
t act = 1 1,0
SE ^
1
1.0816920
0.158374
= 6.83

t act=

P-value = 2 ( | t act
=2(6.83)
=13.66
=1366%(>5%)
Since, P-value>5%, we do not reject Ho. We can be 95% confident that excess market returns does
explain the excess returns of BHP shares.
Q9 (2 mark) Formulate and carry out an appropriate hypothesis test for testing whether BHPs beta
is greater than one at the =0.05 level
Ans:
H0: RBHP=1
H1: RBHP>1

This is a one tailed test, tcrit = +/- 1.645.

^
t act = 1 1,0
SE ^
1
t act =

1.0816921
0.158374
= 0.5158

Q10. (1 mark): Use the data to estimate the Fama-French 3-Factor model given by Equation (2):
r
( mr f )+ B2 SMB + B3 HML+ut
r BHPr f =B 0+ B1
Paste your Eviews output below
Ans:
Dependent Variable: RBHP
Method: Least Squares
Date: 05/29/16 Time: 14:50
Sample: 1 46
Included observations: 46
Variable

Coefficient

Std. Error

t-Statistic

Prob.

C
RM
SMB
HML

0.009590
1.076912
-0.220345
-1.024346

0.007454
0.144980
0.147264
0.254546

1.286617
7.427982
-1.496255
-4.024213

0.2053
0.0000
0.1421
0.0002

R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
Prob(F-statistic)

0.649697
0.624675
0.047636
0.095305
76.85297
25.96535
0.000000

Mean dependent var

S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat

-0.008037
0.077755
-3.167521
-3.008508
-3.107954
2.285920

Y= B0+B1(rm-rf)+B2SMB+B3HML+ut
RBHP = 0.009590 + 1.076912RM - 0.220345 SMB 1.024346 HML
SE =
(0.007454) (0.144980)
(0.147264)
(0.254546)

Q11 (4 marks) In the Fama-French 3-factor model you estimated, test the following hypotheses about
the coefficients B2 and B3. Clearly specify the rejection region if you are using critical values, and
clearly state your conclusions. When using p-values, calculate and compare your p-values to the test
size then state your conclusion. (Hint, assume the Central Limit Theorem Holds)
(a) H0:
(b) H0:
(c) H0:
(d) H0:
Ans:

B 2=0
B 2=0
B 3=0
B 3=0

, H1:
, H1:
, H1:
, H1:

B 2> 0
B 2< 0
B 3> 0
B 3< 0

, with =0.05 using the critical-value approach.

, with =0.05 using the critical-value approach.
, with =0.05 using the p-value approach.
, with =0.05 using the p-value approach.

Q12 (4 marks) Formulate a joint-hypothesis test to test whether the Fama-French 3-Factor model
explains the stock returns better than the model given by Equation (1). Perform the hypothesis test by
calculating the homoskedasticity-consistent F-Statistic, using the formula from lectures. Verify the
value of the F-Statistic by performing the Wald Test in Eviews and using p-values. Paste your Eviews
output below.
Verify your conclusion by performing the Wald test in Eviews and considering p-values. What is your
conclusion?
Ans:

Q13 (4 marks) A Financial Analyst believes that the effect of book-to-market values (HML) on stock
returns is twice as great as the effect of market capitalization (SMB). Formulate an appropriate
hypothesis test and use re-parametrisation to convert it to a simple t-test to test the assertion. Perform
the required regression and paste your Eviews output below. State your conclusion at the 5% level.
Ans: