By Beibei Wang

Part 1: Test of CAPM

The capital asset pricing model denoted by CAPM is widely used in pricing financial assets. It has
not only applied to the simplest case of individual asset return but also well-diversified portfolio
formed by different assets. Under the framework of CAPM, the value of the single asset or portfolio
is estimated by assessing the sensitivity of the single asset or portfolio to the non-diversifiable risk 1.
The fundamental principle of the CAPM is to capture the systematic risk represented by beta (β) that
cannot be reduced. It only takes account the effect of the expected excess return of the market asset
to the excess return of the assets. Basically, the CAPM is stimulated by the following equation.
(rt-rf,t) = α + β(rm,t – rf,t) + ut
According to the Bivariate Regression, if CAPM holds, we will expect that the abnormal return α
equals to zero and coefficient β indicates explanatory power of the market index to the asset value.
Therefore α=0 and β≠0, which means β is significant and α is not.

In order to improve the analysis on the movement of the asset price, more factors are recommended
to add to the original CAPM. The popular Three Factor Model has been introduced by Fama-French
to build up an advanced model by multivariate regression. In Fama’s work, he believes that
additional two factors will contribute to explain excess asset returns, so 3 factor model should fit data
better. on the other hand, if CAPM still holds, we will find that β2=0 and β3=0.
In theory, the 3 factor model is expressed as follows.
(rt-rf,t) = α + β1(rm,t – rf,t) + β2SMBt + β3HMLt + ut

SMB measures the size (or growth) effect. It is calculated based on the return difference (premium)
between small companies and big companies as small companies are thought to have higher returns
than big ones.

HML represents a value factor. It is calculated based on the return difference between the high Book
value to Market value (B/M) of the assets and low B/M of the company’s assets. The higher the B/M
ratio, the higher the returns the undervalued firm can earn.

For further study, a fourth asset pricing factor UMD standing for momentum is suggested to add to
the Three Factor Model. It is calculated by the return difference between a winner portfolio and a

1
Non-diversifiable risk is also known as market risk or systematic risk as it cannot be eliminated by the diversification of the assets in
the portfolio.
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loser portfolio. This factor illustrates people’s behaviour. That is investors always make profits if
they buy winner portfolios and sell loser portfolios. The creative Four Factor Model is expressed as
follows.
(rt-rf,t) = α + β1(rm,t – rf,t) + β2SMBt + β3HMLt + β4UMDt + ut

We run the regression of Four Factor Model by Eviews software and the result is shown below.
Table 1: Regression Analysis
Coefficien
Variable t Std. Error t-Statistic Prob.
C 0.032392 0.01187 2.72894 0.0064
MKT_RF 1.022308 0.011993 85.24345 0.0000
SMB 0.635273 0.021393 29.69602 0.0000
HML 0.693305 0.023449 29.56649 0.0000
UMD 0.044534 0.015677 2.840714 0.0045
　 　
R-squared 0.499469 Mean dependent var 0.073502
Adjusted R-
squared 0.499209 S.D. dependent var 1.467151
S.E. of regression 1.038253 Akaike info criterion 2.913605
Sum squared
resid 8289.58 Schwarz criterion 2.91812
Log likelihood -11205.1 Hannan-Quinn criter. 2.915153
F-statistic 1918.424 Durbin-Watson stat 1.692401
Prob(F-statistic) 0 　 　 　

The dependent variable on the right hand side (RHS) is the excess return of the oil. The independent
variables on the LHS are excess return of market index, growth factor (SMB), value factor (HML)
and momentum (UMD). Then Eviews gives the following equation given each time series.
(OIL_RF)t = 0.032 + 1.022(MKT_RF)t + 0.635SMBt + 0.693HMLt + 0.045UMDt + ut

For convenience, we compare the outcome of all coefficients for discussion in table 2.

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Table 2: Coefficient Analysis

Reject Do not reject
Null Hypothesis: Alternative Hypothesis: t-statistic p-value
H0? H0?
α=0 α≠0 2.72894 0.0064  　
β1 = 0 β1≠0 85.24345 0.0000  　
β2 = 0 β2≠0 29.69602 0.0000  　
β3 = 0 β3≠0 29.56649 0.0000  　
β4 = 0 β4≠0 2.840714 0.0045  　
Chi
Wald test of coefficient restrictions p-value 　 　
Squared
β1 = β2 β1≠β2 313.3888 0.00%  　
β2 = β3 β2≠β3 3.8410 5.00% 
β3 =β4 β3≠β4 727.0399 0.00%  　
β1 = β2 = β1≠β2≠
 　
β3 =β4 β3≠β4 3325.0230 0.00%

The first part records the results (table 1) of significance of estimated coefficients (β 1, β2, β3 and β4)
respectively based on a two-sided 5% hypothesis test. The null hypothesis states that the coefficients
are zero, which means the factors have no explanatory power to the oil return. It displays that
coefficients are significant as their corresponding p-values are lower than 5%. Then we have to reject
the null hypothesis of zero value. Therefore, it indicates that abnormal return denoted by α exists. Oil
price are sensitive to the four factors at different levels. Furthermore, the positive relationships
between them indicated that the larger the change of the value of the factors, the higher the excess
return of oil is. For example, if one of four factors (excess return of market index, SMB, HML and
UMD) increases by 1 given other factors unchanged, the excess return of oil will rise up by 102.2%,
63.5%, 69.3% and 4.5% respectively. So the return of oil responses to the market index changes on
the nearly one-to-one basis and more than half to the growth and value factor. But the momentum
factor has less effect on the oil return although it is proved to be significant.

The second half of table two shows the outcome of the multiple hypotheses done by Wald test of
Coefficient Restrictions. We set the restrictions of β1 = β2, β2 = β3, β3 = β4 and β1=β2=β3=β4. The Wald
test gives F-statistic and a Chi-squared statistic. As the p-value under the Chi-squared distribution is
very similar to that of F-statistic, we only consider the former for simplicity. The zero p-values to the
restrictions except for β2 = β3 indicate the rejection of the hypothesis. So the coefficients are different
from each other. But β2 is almost equal to β3 under the 5% conference level. (need more data or
observations for modelling)

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Diagnostic tests:
There are basically three tests we need to perform. One is the F-statistic with its probability. It is
used to test none of the explanatory variables has explanatory power. It is a joint hypothesis test that
all coefficients excluding intercept equal to zero. The zero p-value in our case states that all
coefficients are significant. The second one is R-Squared or Adjusted R-squared. It is used to
measure how many percent of the variation in the dependent variable is explained by the regression.
The adjusted R-squared takes account the problem that R-squared always when you add variables to
a regression by subtracting a small penalty for one more variable. The (Adjusted) R-squared is
around 50% in this example. That is, the changes of the oil return can be half explained by the
regression. The last one is Durbin-Watson statistic for checking serial correlation. If it is close to 2,
the autocorrelation does not exist. The value of DW is 1.7 and it means there is probably no
relationship between ut and ut-1.

Other information:
In general, diagnostic tests state that all coefficients are significant; model roughly fits the data and
no autocorrelation between the residuals. So we need to improve the model as the R-squared is not
high. We need to further study the relationship between the SMB and HML as they seem to have
equal effect on the oil return based on the coefficient test by Wald. We can increase the observation
for modelling.

In addition, there are more diagnostic tests on residuals we need to do for satisfying the OLS
modelling requirement. We will discuss this in next part.

Part 2: Audit fees

The pioneering studies on the Audit fees modelling point out that relevant explanatory variables and
their expected relationship with Audit Fess. For simplicity, we only consider general factors, such as

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firm size, audit risk and complexity. Before that, we want to list the selected variables and the
expected outcome.
Table 3 Historical outcome

According to the empirical research, the audit fee differences due to the changes in loss exposure,
audit quality and audit production functions. We will illustrate the effect of each factor on audit fee
as follows.

Based on cross-sectional data Pong and Whittington (1994) further develop a supple and demand
model in which supply is determined by the auditor’s cost function (audit fee) which concerns the
audit quantity. Because the regulation sets up minimum audit standards, the demand for external
audit services is assumed to be inelastic and depends on the required amount of audit work. That in
turn results in strong relationship between the auditee size and audit production. (Clatworthy & Peel
(2006)) Prior literature suggests that extra audit fees would be changed for the compensation to
incremental litigation risk. Loss exposure also known as audit risk is positively associated with
higher audit fees due to increased audit effort rather than higher fees per hour. Simunic (1980) put
forward that loss exposure increases when clients become more complex. Complexity is suggested
to be modelled by the number of subsidiaries and sales outside UK of total assets, since Clatworthy
& Peel states “whether or not extraordinary or exceptional items were disclosed in the annual
account to capture incremental complexity in the audit.” In addition, we include one binary variable
to indicate whether the company is audited by a leading auditor (BIG4) as a premium will paid for a
higher quality audit in line with associated signalling/brand/reputational effects.

From the Table 3, the prior study tells us that factors are expected to be positively related to the audit
fee except for RETSAL (one of Auditor risk). However, empirical literature did not take account of
current ratio which is the current assets divided by current liabilities (cacl). Current ratio is used to
measure the liquidity of a company. We consider current ratio as a kind of Audit risk since a
company’s liquidity is related to Audit risk.

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Based on the theoretical model, we run the regression by Eviews and the results show in table 4.
Table 4 Audit fees
Variable Coefficient Std. Error t-Statistic Prob.
C 1.756047 0.063014 27.867490 0.000000
LOGSAL 0.283538 0.008201 34.574960 0.000000
LOGTA 0.179776 0.008315 21.619570 0.000000
EXPSALES 0.568968 0.069901 8.139599 0.000000
NSUBS 0.014321 0.001050 13.639400 0.000000
TLTA 0.053918 0.010459 5.155391 0.000000
RETTA -0.009628 0.011914 -0.808116 0.419100
CACL -0.000050 0.000034 -1.481707 0.138500
BIG4 0.352765 0.035292 9.995521 0.000000
　 　
R-squared 0.777385 Mean dependent var 8.034533
Adjusted R-
0.777029 S.D. dependent var 1.398717
squared
S.E. of regression 0.660472 Akaike info criterion 2.010075
Sum squared resid 2177.191000 Schwarz criterion 2.021806
Log likelihood -5016.187000 Hannan-Quinn criter. 2.014186
F-statistic 2178.614000 Durbin-Watson stat 1.945700
Prob(F-statistic) 0.000000 　 　 　

In this example, audit fee is measured by the auditee size, auditee complexity, and audit risk and
additional dummy variable Auditor size. They are positively related to the change of the audit fee
except two elements (RETTA and CACL) from audit risk factor. But not all of them are significant
under 5% confidence level. Then we move to the hypothesis tests on the coefficients. (See Table 5)
Table 5: Coefficient Analysis
Null Alternative Reject Do not reject
Variable t-statistic p-value
Hypothesis: Hypothesis: H0? H0?
C α=0 α≠0 27.86749 0.0000 
LOGSAL β1 = 0 β1≠0 34.57496 0.0000 
LOGTA β2 = 0 β2≠0 21.61957 0.0000 
EXPSALES β3 = 0 β3≠0 8.139599 0.0000 
NSUBS β4 = 0 β4≠0 13.6394 0.0000 
TLTA β5 = 0 β5≠0 5.155391 0.0000 
RETTA β6 = 0 β6≠0 -0.808116 0.4191 
CACL β7 = 0 β7≠0 -1.481707 0.1385 
BIG4 β8 = 0 β8≠0 9.995521 0.0000 

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The zero p-values indicate significant variables, so sales, total assets, subsidiaries, ratio of exports to
sales, ratio of total liabilities to total assets and dummy variable have explanatory power to determine
the audit fee. The sign of each variable is tested to consist with the expectation in table 3. We express
the regression as follows.
LOGAFEEt = 1.756 + 0.284LOGSALt + 0.180LOGTAt + 0.569EXPSALESt + 0.014NSUBSt +
0.054TLTA t + 0.353BIG4t +ut
If one of explanatory variables (LOGSAL, LOGTA, EXPSALES, NSUBS, TLTA, RETTA, CACL)
increases by 1 given other factors unchanged, the audit fee will rise up by 28.35%, 17.80%, 57.90%,
1.43%, 5.49% and 35.28% respectively. Additionally, the dummy variable BIG4 is significant,
which means a auditor with higher reputation and quality of service will increase the audit fee. If a
company choose a BIG 4 auditor, its audit fee will go up by 35.3%, otherwise 0.

Diagnostic tests:
Similar to CAPM, we will perform basic diagnostic tests to verify the validity of the regression
model. We will begin with the F-statistic with its probability. It is a joint hypothesis test that none of
the explanatory variables are significant (excluding intercept equal to zero). The corresponding zero
p-value (in table 4) states that all coefficients are significant, even it is not true if we do it
individually. Secondly, R-Squared or Adjusted R-squared assesses the goodness of fit by measuring
how many percent of the variation in the dependent variable is explained by the regression. The
adjusted R-squared is superior to R-Squared as what discuss above. The (Adjusted) R-squared is
around 77.7% in this example. That is, there is 77.7% changes of the audit fee can be explained by
the regression. The last one is Durbin-Watson statistic for checking serial correlation. If it is close to
2, the autocorrelation does not exist. The value of DW is near 2 and it demonstrates that there is no
positive or negative correlation between ut and ut-1.

Other information:
Generally, the model fits the data and it has been proven by high (Adjusted) R-Squared. F-statistic
shows significant coefficients by testing together. DW test states no autocorrelation between the
current residual and the last residual. But it does not give any information about the relationship
between the current residual and historical data. We need to apply advanced serial correlation tests
such as Breusch-Godfrey Serial Correlation LM test to check the higher order.
Empirical literature suggest using log (NSUBS+1) instead of the original NSUBS as variable take
advantage of better fit. So we can use this specification of NSUBS to run the model.

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Secondly, we need to take account of the characteristics of the data before we run a multivariate
model, such as stationarity and the multicolinearity between the independent variables.
Thirdly, when we employ the OLS estimator, we have to make sure the data satisfy the assumption
of the CLRM-classical linear regression model. We need more information from the diagnostic tests
on the residuals, such as Heteroscedasticity (White Heteroscedasticity test), normality (Jarque-Bera
test) and stability (Chow test).

Reference:
Chris Brooks (2002), Introductory Econometrics for Finance, Cambridge University Press.

Clatworthy, M. A. and Peel, M. J. (2007). The effect of corporate status on external audit fees: Evidence from the
UK. Journal of Business Finance and Accounting 34 (1) and (2), 169-201.

Pong, C. and G. Whittington (1994), ‘The Determinants of Audit Fees: Some Empirical Models’, Journal of
Business Finance & Accounting, Vol. 21, No. 8, pp. 1071–95.