EVALUATION GUIDELINES - Written examination

Component of continuous assessment

GRA 65151
Quantitative Methods for Finance

Department of Finance

Start date: 06.12.2018 Time 09:00

Finish date: 06.12.2018 Time 12:00

For more information about formalities, see examination paper.

 GRA6515 Quantitative Methods for Finance
Fall 2018
Final Exam
— Thursday, December 6, 2018 —

Total 100 points

1. Linear Regressions and Descriptive Statistics (39 points).

You would like to study the dependence between delinquency rate on loans and banks tightening
the lending standards. For your analysis, you download two quarterly time series spanning the
period from 1991 to 2017: delinquency rate on commercial and industrial loans (Xi ) and net
percentage of domestic banks tightening standards for commercial and industrial loans (Yi ). As
an outcome of your analysis you obtain the following results:
ņ ņ ņ
Xi  476.7, pXi
X q  50027,
2
pXi
X qpYi
Y q  968.99,

i 1 
i 1 
i 1
ņ ņ
Yi  257.39, pYi
Y q2  194.4.

i 1 
i 1

For the following questions use α  0.05 as your significance level and present your results with
4 digits after the decimal point. For hypothesis testing, no tabulated percentiles of distributions
will be provided. State explicitly the decision rule and formula to compute necessary critical
values.

(a) Calculate the sample mean, variance, and standard deviation for X and for Y . (2 points)
n  108, apply the definitions (lecture 4) for sample mean, variance and standard deviation
(b) Calculate the sample covariance and the correlation between X and Y . Is this correlation
statistically significant? Describe precisely how you test it. (3 points)
Use the definition of sample covariance and correlation from lecture 6 (regression analysis). Last
slide of lecture 5 (hypothesis testing) presents the test statistic and associated distribution. The
decision rule is analogous to any test with t-distribution.
(c) For a regression model Yi  β0 β1 Xi ui , find the coefficient of determination. Interpret
your results. (2 points)
The coefficient of determination is equal to the square of the correlation.
(d) Find the total variation, explained variation, and unexplained variation of Y . (2 points)
Total variation is given. Use R2 to compute explained variation and then residual sum of squares.

(e) Calculate the estimates β̂0 and β̂1 for the regression Yi  β0 β1 Xi ui . (3 points)
See slide 16, lecture 6 (regression analysis).
(f) Find standard errors of the estimates. What can you say about the significance of β0 and
β1 ? (5 points)
See slides 21, 26, lecture 6 (regression analysis).
(g) Show how you can use F-test to test the significance of β1 . Compute the test statistic and
state the decision rule. (7 points)
Here, the test of significance β1 is equivalent to using the F-test for ‘junk regressions’. In
particular, the restricted sum of square is equal to the total variation of Y , the unrestricted sum
of squares is the residuals sum of squares of the estimated regression. See slide 13, lecture 6
(multivariate regression analysis).

2
 (h) Explain why it is important to include a constant into a regression model. Derive β̂1nc ,
that is, the slope coefficient in the no-constant version of the regression Yi  β1nc Xi ui .
Compute β̂1
β̂1nc . (7 points)
The regression line will be forced to go through the origin of the axes. As a result, the slope
coefficient will be biased. Repeating the derivation steps (see lecture notes), we can derive β̂1nc
and see that is biased.
(i) Do the two time series in your analysis have statistically different volatilities? Describe
precisely how you test it. (3 points)
To test the difference of volatilities we use the F-test for variances. See slides 34-36, lecture 5
(hypothesis testing).
(j) On average, is delinquency rate on loans statistically different from the net percentage of
banks tightening their lending standards? Describe precisely how you test it and explain
your choice of the test. (5 points)
Since the data span the same period of time and may be dependent, two variables should be
treated as paired.

2. Limited Dependent Variable (23 points).

The theory of firm financing suggests that corporations should use the cheapest methods of
financing their activities first (i.e. the sources of funds that require payment of the lowest rates
of return to investors) and switch to more expensive methods only when the cheaper sources
have been exhausted. Helwege and Liang (1996) examine the pecking order hypothesis in the
context of a set of US firms that had been newly listed on the stock market in 1983, with their
additional funding decisions being tracked over the 1984-92 period. A core objective of the paper
is to determine the factors that affect the probability of raising external financing. As such, the
dependent variable will be binary that is, a column of ones (firm raises funds externally) and
zeros (firm does not raise any external funds).

(a) Explain the term ‘limited dependent variable’. (1 point) See Lecture 6 (limited dependent
variable models) for the definition.
(b) Explain why a linear probability model is inappropriate for the analysis. (3 points) See
Lecture 6 (limited dependent variable models), slide 6.
(c) The table below documents the results from the logit regression (t-statistics are in paren-
theses). The explanatory variables are a set of firm characteristics that aim to capture the
relative degree of information asymmetry and degree of riskiness of the firm. The variable
‘deficit’ measures (capital expenditures + acquisitions + dividends earnings); ‘assets’ is
used as a measure of firm size; ‘industry asset growth’ is the average rate of growth of assets
in that firm’s industry over the 1983-92 period; ‘previous financing’ is a dummy variable
equal to 1 for firms that obtained external financing in the previous year.
Logit estimation of the probability
of external financing Descriptive statistics
Variable (1) (2) Variable Mean Std. dev.
Intercept -0.29 -0.72 Deficit 0.10 0.40
(-3.42) (-7.05) Assets 80.91 231.52
Deficit 0.04 0.02 Industry asset growth 50.86 33.04
(0.34) (0.18) Previous financing 0.40 0.01
Assets 0.0004 0.0003
(1.99) (1.36)
Industry asset growth -0.002 -0.002
(-1.70) (-1.35)
Previous financing 0.79
(8.48)
Specify the logit model for regression (1). How can this model be estimated? (3 points)

3
 See Lecture 8 (limited dependent variable models), slide 7.
(d) For logit regression (1) comment on the sign and the significance of the regression coeffi-
cients. (3 points)
We can interpret the signs of the coefficients and their significance as in the OLS case.
(e) How is the probability of raising external financing affected by 1 unit increase in the firm’s
deficit? 1 unit increase in the firm’s size? 1 unit increase in industry asset growth? Explain
your calculations. (6 points)
Compute marginal effects: see the notes for lecture 8.
(f) Explain how you would measure the goodness-of-fit for the regressions (1) and (2). (3 points)
See Lecture 8 (limited dependent variable models), slide 9.
(g) How does the interpretation of the intercept change in regression (2) compared to the
regression (1)? (4 points)
See Lecture 7 (multivariate regression analysis), slide 15.

3. True or False (22 points total, 2 points each).

Are the following statements true or false? Explain your answers briefly. Without an explanation
the answer will be given zero points.

(a) Given that the interest rate is equal to 11%, the present value of a prize that brings $20,000
per year forever with the first payment at the end of the forth year and continuous com-
pounding of interest is higher than the present value of a prize that pays $60,000 every
three years (paid out at the end of a three-year period) for the next 15 years (5 payments
in total).
False. The present value of second claim is higher. See lecture 1.
(b) The multiplication rule for probabilities P pAB q  P pA|B qP pB q can be applied for inde-
pendent events A and B.
True. The formula is still valid.
(c) To compute the sample variance we divide the sum of squared deviations from the mean
by n
1 to make the estimator consistent.
False. It is not consistency.
(d) A regression model where individual slope coefficients are insignificant and R2 is equal to
90% suffers from near-multicollinearity.
True. It happens when regressors are highly correlated and vairance-covariance is close to sin-
gular.
(e) The Poisson distribution is often used to model the dynamics of a stock price.
False/True. We use it to model extreme events in stock returns.
(f) Bootstrap might be ineffective for linear regressions when the error terms are heteroskedastic
or autocorrelated.
True, block bootstrap could be more effective in this case.
(g) The model yt  eα xβt eut cannot be estimated using OLS. Here, yt , xt are data series and α
and β are parameters to be estimated.
False. Modify the equation by taking logarithm of both sides and apply OLS.
(h) To identify key characteristics of individuals applying for bank loans, a researcher obtains
anonymized data from the largest bank in the country. These data contain extensive in-
formation about customers that currently have an outstanding loan from the bank. The
researcher is right to treat the data as a simple random sample.
False. Sample selection bias.
(i) The best way to study the wealth distribution in the world is to collect a large random
sample from the population.
False. Stratified sampling.

4
 (j) One of the reasons of the conditional heteroskedasticity in error terms is that the regression
model omits an important variable which is persistent.
False. Autocorrelation.
(k) We can use Monte Carlo simulations to compute an integral of a function.
True. See lecture 9.

4. MATLAB (16 points total).

You are given an excerpt from a MATLAB code.
01: smb = 100*data(:,6);
02: hml = 100*data(:,7);
03: n = length(smb);
04: x = corr(smb, hml);

05: r = 1000;
06: X = zeros(r,1);
07: for b=1:r
08: data b = datasample([smb hml],n,’Replace’,true);
09: X(b,1) = corr(data b(:,1),data b(:,2));
10: end

11:se b = std(X);
12:q = norminv(0.975,0,1);
13:int 1 = [mean(X)-q*std(X); mean(X)+q*std(X)];
14:int 2 = [prctile(X,2.5); prctile(X,97.5)];

Here smb and hml are Fama-French size and value factors.

(a) Explain what the code in lines 1 to 4 does. In general, what is the difference between
correlation and regression analysis? (3 points)
Correlation of two factors.
(b) Explain what the code in lines 5 to 10 does. What is the objective of this method? (5 points)
Bootstrap of correlation.
(c) Explain the code in lines 11–14. What statistic is computed in lines 13–14? Do you expect
the values of the variables int 1 and int 2 to be similar? Why?(5 points)
Two confidence intervals should be the same.
(d) How can you use the values of the variables int 1 and int 2 to test the significance of the
correlation coefficient? (3 points)
Test whether zero is within the confidence interval.

5
Time Value of Money.

Annuity: Perpetuity Growing Perpetuity


p 1 r q
1
 

N  8 8
P V0  A 1
p1 r rq  A ° pp11 qi  A p1r
ggq
°
F VN A N
P V0 A p
1
qi  Ar P V0 g
qi
i1 
r 1 r r
i 1

Probability Theory.

P pA Y B q  P pAq PpB q
PpA X B q, PpA X B q  PpA|B qPpB q  PpB |AqPpAq

The Total Probability Rule Bayes’ Rule

PpAq  PpA X E1 q PpA X E2 q  PpA X En q PpEj |Aq  ° j p | qp q

P AE P E
j

PpA|Ei qPpEi q
n

i1

EpX q  EpX |E qPpE q EpX |E C qPpE C q  EpX |E1 qPpE1 q EpX |E2 qPpE2 q    EpX |En qPpEn q
° °
EpX q  Xi PpXi q EpY q  Epg pX qq  g pXi qPpXi q
n n


i 1

i 1
V arpX q  E pX
EpX qq2  ° pXi
EpX qq2 PpXiq Cov pX, Y q  σX,Y  E prX
EpX qsrY
EpY qsq
n

i1

ρpX, Y q  ρX,Y  ?Cov pX,Y q  σσ σ X,Y

σ pX qσ pY q 2 2 X Y

EpaX bY q  aEpX q bEpY q, EpaX cq  aEpX q c, σ 2 pX q  EpX 2 q
pEpX qq2

σ 2 paX bY q  a2 σ 2 pX q b2 σ 2 pY q 2ab Cov pX, Y q σ 2 paX cq  a2 σ 2 pX q

If X1 , X2 , ..., Xn are independent, Cov pX, Y q  EpXY q
EpX qEpY q


° °
 σ 2 pXi q
n n
σ2 Xi

i 1 
i 1

X  B pn, pq X  P oissonpλq
ppxq  PpX  xq  pn
n!xq!x! px p1
pqn
x PpX  k q  λk! e
λ , k  0, 1, 2, . . .
k

X  U ra, bs
$
$
'
'
'
'
' 0, for x ¤ a
& 1 &
f px q 
b a
for a x b
F px q 
, for a
x a
' ' b
a x b
% 0 otherwise '
'
'
% 1, for x ¥ b.

EpX q  a b
V arpX q  pb
aq2
2 , 12

X  Np q µ, σ 2 Y  eX  LN pµ, σ2q


f pxq  ?2πσ exp
px2σ

µq
8 8 EpY q  E eX  eEpX q p q  eµ
2 1
1
, for x 2
V ar X 0.5σ 2
2

• χ2 distribution: If z1 , z2 , .., zn are standard normal independent random variables, then κn 

z12 z22  zn2 is χ2 distributed with n degrees of freedom.

• F-distribution: If κn  χ2pnq and κm  χ2pmq are independent, then κκ {{mn  F pn, mq. n
m

• t-distribution: If z is standard normal, κn  χ2pnq, z and κn are independent then ?κz {n has n

t-distribution with n degrees of freedom.

 °n
i1 pXi
X q
 n1 ° Xi  ?σn , sX  ?sn , s2 
n 2
X
i 1 
σX n 1

Stratified Sampling
°
 ° NNX
nl
 n1
L
Xl Xil Xs l l
l
i 1 
l 1
L

°
2
 n 1
1 °
nl
 1
Xil
X l
2
Nl 1 nl
sX s s2l , where s2l

l 1
N nl Nl l
i 1 °
sXY 1 °
 n
1 pXi
X qpYi
Y q
n
Skew  pn
1qpn
2q n
n
i 1  p X
X q i
3

i1
s3
°
npn 1q
KurtE  pn
1qp  pX
X q
3pn
1q
n 4
i 2

n
2qpn
3q pn
2qpn
3q
i 1
s 4

Hypothesis Testing.

t pX1d
X2 q
pµ1
µ2 q , df  n1 n2
2, s2p  pn
1nqs p
q

2 n2 1 s22
1
Equal but unknown variances

1
2sp 2 sp 1 n2 2
n1 n2

t pX1d
X2 q
pµ1
µ2 q , df  pss {{nn { q

2 2
1 1 s22 n2
Unequal and unknown variances 2s1 2 s2
4
1
3
1 {
s42 n32
n1 n2

Test of a single variance TS  pn
σ1qs 2

0
2
χ2n
1

TS  s F pdf1 , df2 q, dfi  ni
1,

s 2
Test to compare two variances 1
2
? 2

Correlation test T S  r? n
2 s

tn
2
1
r 2
s

Regression Analysis.
°N
β̂1 °1Npyi
yqpxi

i xq
 ss
xy
β̂0  y
β̂1x β̂  pX 1X q
1X 1Y
i1 px
x q2 2
x c °
i

b

 
SE β̂1  s ° 1 s  E pβ̂
β qpβ̂
β q1
1
x2i
°N
pxi
xq2 SE β̂0 pxi
q x 2
V ar β̂

 pX 1X q
1X 1E ruu1s X pX 1X q
1

 pX 1X q
1X 1pσ2I qX pX 1X q
1  σ2pX 1X q
1
û1 û
 N1
2 ° û2i s2  N

N
s2 k
1

i 1
°  
 ESS
T SS  1
T SS  1

°py
ŷ q  1
n
n
k
1 1 1
R2 , pseudo
R2  1
LLF
2 2
RSS LLF
R2 py
yq
i
i
i
2 , R 0

F-test T S  RRSS
U RSS  n
k
1  F pm, n
k
1q

U RSS m

Wald-test pRβ̂
qq1 pRpX 1 X q
R1 q
pRβ̂
qq  F pm, n
k
1q

1 1

ms 2

°
DW  pûi
ûi
1q2{ ° û2i
n n
Durbin-Watson test
i 2 
i 1

White test nR2  χ2m

Breusch-Godfrey test pN
rqR2  χ2r

 
Jaque-Berra test W  n skew pkurt
3q  χ2 2 2

6 24 2

Chow test
pRSS RSS q n
2pk 1q  F pk

T S  RSSRSS 1 2
1, n
2pk 1q
RSS k 1 1 2

 F pziq, zi  β0  F p zi q  1 B Pi
 F p z qβ j
Logit model Pi β1 X1i βk Xki ui , p
q B
1 exp zi , Xj
z³i
Probit model Pi  F pzi q, zi  β0 β1 X1i  βk Xki ui , F p zi q  ?1 { 2
ez 2 dz

8
2π