11/10/2021

TCH442E

QUANTITATIVE
METHODS FOR FINANCE

Dr. Quyen Do Nguyen

quyendn@ftu.edu.vn

Last Lecture:
• Hypothesis testing for a single
coefficient.

Next:
• More on hypothesis testing.
• Testing joint hypotheses.
• Testing a single restriction on
multiple coefficients.
• Model’s specification.

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Review of
Hypothesis Testing
Single Coefficient
t= ˆ  E(ˆ )
1 1

var(ˆ1 )
If n>30, then t~N(0,1); if n<30, then t~Student t distribution.

 Hypothesis testing on a single coefficient such as 1: t-statistic

and confidence intervals {ˆ  1.96SE(ˆ )}.
1 1

 Problem: in a regression with many regressors

(1, 2…, k), the betas are generally not
independently distributed – so their t-statistics will
also not be independently

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Back to Class Size Data

Model 1: TestScore = 698.9 – 2.28STR
(10.4) (0.52)
Model 2: TestScore = 686.0 – 1.10STR – 0.650xESL
(8.7) (0.43) (0.031)

 The coefficient on STR in Model 2 is the effect on TestScore of a unit change in STR,
holding constant ESL.
 The 95% confidence interval for the coefficient on STR in Model 2 is
{–1.10  1.960.43} = (–1.95, –0.26). Consistently, the t-statistic for the null  STR = 0 is
t = –1.10/0.43 = –2.54, so we reject the null at 5% significance level.
 The 99% confidence interval for the coefficient on STR in Model 2 is{–1.10 
2.580.43} = (0.009, –2.209). Consistently, |-2.54|<2.58,
thus we fail to reject the null at 1% significance level.

Tests of Joint Hypotheses

Consider a new variable, EPP = school expenditures per student. The regression
model is now:
TestScorei = 0 + 1STRi + 2EPPi + 3ESLi + ui

It can be interesting to test the null hypothesis that “school resources

don’t matter,” (i.e. both STR and EPP) versus an alternative hypothesis
that any of them does matter:

H0: 1 = 0 and 2 = 0
vs. H1: either 1  0 or 2  0 or both

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Tests of Joint Hypotheses

H0: 1 = 0 and 2 = 0
vs. H1: either 1  0 or 2  0 or both

A joint hypothesis specifies a value for two or more coefficients, that is, it
imposes a restriction on two or more coefficients.
In general, a joint hypothesis will set a given number of
restrictions, q>1. In the example, q = 2, and the restrictions are 1
= 0 and 2 = 0.
We cannot use individual t-statistics to test such hypothesis. We need a
statistic that takes into consideration that the t- statistics are not
independently distributed.
This is the F-statistic.

The F-statistic
The F-statistic is used to test a joint hypothesis.
In the special case of the joint hypothesis 1 = 1,0 and 2 = 2,0 in a
regression with two regressors, F-statistic has a simple formula:

1  t1  t2  2ˆt1 ,t2t1t2 
2 2
F=
2  1 ˆ t21,t 2 


where ˆ t1 ,t2 estimates the correlation coefficient between t1 and t2.

Reject the null when F is large (when t1 and/or t2 is large).

The formula for more than two betas is complex. However, there
is a large-sample approximate distribution.

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Large-Sample Distribution
of the F-statistic
p
In the special case of t1 and t2 being independent, ˆ t1,t2  0, so:

1  t1  t22  2ˆt1 ,t2 t1t2   1 (t 2  t 2 )

2

F=
2  1 ˆt21,t2  1 2
 2

The t statistics follow a standard normal distribution (Central Limit

Theorem). Therefore, the large-sample approximate distribution of the
F-statistic is the distribution of the average of two independently
distributed squared standard normal random variables.

The q (Chi-squared)
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The Chi-squared distribution with q degrees of freedom (  q )
is defined as the sum of q independent squared standard normal
random variables.

In large samples the F statistic follows a Chi-squared distribution

with q=number of restrictions.

Critical values for the Chi-squared distribution are reported at the

back of any standard Econometrics textbook.

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Computing the F-test

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Homoskedasticity-Only F-statistic

When the regression errors are homoskedastic, there is a simple

formula for computing the “homoskedasticity-only” F-statistic:

Run two regressions, one under the null hypothesis (the “restricted”
regression, i.e. the model under the null that one or more regressors
equal zero) and one under the alternative hypothesis (the
“unrestricted” regression).
Compare the fits of the restricted and unrestricted regressions (the R2):
if the “unrestricted” model fits sufficiently better, reject the null.

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Homoskedasticity-Only F-statistic

 The bigger the term (R 2unrestricted  R2restricted ), i.e. the greater the
improvement in fit, the larger the F statistic.

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Back to Class Size Data

Note: Heteroskedasticity-robust F = 5.43…

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The Fq,n–k–1 Distribution

If the four multiple regression LS assumptions hold and:
5. ui is homoskedastic, that is Var(u|X1,…,Xk) does not depend
on X’s.
6. u1,…,un are normally distributed.

then the homoskedasticity-only F-statistic has the “Fq,n-k–1”

distribution, where q = number of restrictions and k = number of
regressors under H1 (i.e. number of regressors in unrestricted model).

 As n  , the F q,n-k–1 distribution asymptotes to the  q2

distribution (the F distribution is to the  2q distribution what
the tn–2 distribution is to the N(0,1) distribution).

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Testing Single Restrictions on Multiple

Coefficients

Yi = 0 + 1X1i + 2X2i + ui, i = 1,…,n

Consider the null and alternative hypothesis,

H0: 1 = 2 vs. H1: 1  2

This null imposes a single restriction (q = 1) on multiple

coefficients – it is not a joint hypothesis with multiple restrictions.

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Testing Single Restrictions on Multiple

Coefficients
Two methods for testing single restrictions on multiple
coefficients:
1. Perform the test directly
2. Transform the regression
Yi = 0 + 1X1i + 2X2i + ui
H0: 1 = 2 vs. H1: 1  2
Add and subtract 2X1i:
Yi = 0 + (1 – 2) X1i + 2(X1i + X2i)+ ui or

Yi = 0 + 1 X1i + 2Wi + ui
(where 1 = 1 – 2 and Wi = X1i + X2i)

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Testing Single Restrictions on Multiple

Coefficients
Before transformation
Yi = 0 + 1X1i + 2X2i + ui
H0: 1 = 2 vs. H1: 1  2

After transformation:
Yi = 0 + 1 X1i + 2Wi + ui

where 1 = 1 – 2 and Wi = X1i + X2i

so
H0: 1 = 0 vs. H1: 1  0

The testing problem is now a simple one: 1 = 0!

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Testing Single Restrictions on Multiple

Coefficients
• Simple command in Stata to perform the test directly after a regression:
ttest

• Take-home assignment:
Consider the regression model with STR, EPP and ESL:

TestScorei = 0 + 1STRi + 2EPPi + 3ESLi + ui

Test the null hypothesis that the impact of STR is the same as the impact
of EPP versus the alterative hypothesis that their impact differs. That is,
test:
H 0:  1 =  2
vs. H :  ≠

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Heteroskedasticity and Homoskedasticity

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Example:
Hourly Earnings and Years of Education (Data
From US Current Population Survey)

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Heteroskedasticity and Homoskedasticity

in Practice…

Homoskedasticity standard errors are valid only if the errors

are homoskedastic.
Heteroskedasticity – robust standard errors are valid
whether or not the errors are heteroskedastic.
If the errors are heteroskedastic and heteroskedasticity –
robust standard errors are not used, the t-statistics and the
confidence intervals will be wrong, usually two small.

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THANK YOU!

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