Econ 143 UCLA Aprajit Mahajan

May 9, 2013 Problem Set 3

Problem Set 3
Due in the Academic Oce (8283 Bunche) on Tuesday, May 21 by 4:00PM.

1. Stock and Watson: (on p.241-2 Review the Concepts): 7.1, 7.2 (on p.242-244): 7.2, 7.4, 7.6 (on p.296-297): 8.2 (on p.340-341 Review the Concepts): 9.1, 9.5 (on p.341-) 9.2, 9.5, 9.7 2. Consider the model Y = 0 + 1 X + U and suppose that E (U |X ) = 0. (a) How would you estimate 1 if you observed an i.i.d. sample from the joint distribution of Y, X ? (b) Suppose that you observe instead an i.i.d. sample {Yi , Xi }n i=1 where Xi is a mismeasured version of Xi . Specically, Xi = Xi + Vi What is the probability limit of the OLS estimator of the slope coecient in a regression of Y on X and does it equal 1 ? (c) Now suppose that Cov (X , V ) = 0 and Cov (U, V ) = 0. Simplify the formula in part (b) above and interpret the form of the bias. 3. ( The Capital Asset Pricing Model (CAPM): Testing Implications) We will use some basic nance theory to motivate a particular linear regression and attempt to interpret its coecients and residuals in light of this theory. The CAPM is an equilibrium model for expected returns on nancial assets (such as stocks) and is based on the following stringent assumptions: There is a market with many assets and there are many equally informed investors, who are all price takers and who plan to invest over the same time horizon and face no taxes or transaction costs. All investors can borrow or lend at a risk free interest rate (which is dened as the return on a completely risk free asset) and only care about two features of the distribution of asset returns, the

2 mean and variance. Specically, they like high means and dislike high variances (risk in this set up is equated with variance). We will discuss one particular implication of this theory, which is that the following pricing relationship exists for all assets E (Rit ) = rf t + i E (RM t rf t ) (1)

where Rit 1 denotes the return on asset i in period t, RM t is the return to the market portfolio2 in period t. The term rf t refers to the risk free rate of return.3 This equation says that the relationship between the expected return on an asset and the expected return on the market portfolio is linear with the multiplicative constant being the beta of that asset with the market portfolio. (a) True or False: Given a value for E (RM t rf t ) (called the market risk premium), the higher the beta on an asset, the higher the expected return on the asset and vice-versa. (b) We will test a simple prediction of the CAPM model. Consider the model (for asset i) given by Rit = i + i RM t + it t = 1...T (2) where we assume that the unobservable error term it is independent of RM t with mean zero and unknown variance 2 . We also assume that {Rit , RM t , rf t }T t=1 is an i.i.d. sample4 . Does this model satisfy the assumptions in Key Concept 4.3 of Stock and Watson? (c) Next, we can add and subtract the risk free rate of return to both sides of (2) and also add and subtract i rf t from the right hand side of (2) to obtain Rit rf t = i (1 i ) rf t + i (RM t rf t ) + = i + i (RM t rf t ) + it
it

(3)

Using the CAPM implication, (1) show that the CAPM implies that i i (1 i )rf t = 0. We will test this prediction of CAPM in the data.

(d) We now take these and some other implications of the CAPM to real data. You are given the le capm3.dta on monthly stock returns for 15 companies in 7
The rate of return on an asset is dened as the dierence between the nal and the initial price (plus any dividends) divided by the initial price. In the empirical example, you will see how these are constructed. 2 By a portfolio, we mean a collection of assets. By the market portfolio we mean a collection of every asset in the market, which are held in proportion to the proportions that they exist in the market. The rate of return on this portfolio is typically operationalized by constructing a value weighted average of returns of the assets in the market. 3 This is usually taken to the rate of return on Treasury Bills. 4 For the time being, we ignore correlation across time which is very present in stock returns. We will look at this in more detail later in the course.
1

3 industries from 1/1978-12/1987.5 The le also contains information on the market monthly return Rmt which is a value-weighted average of returns on stocks listed in the New York Stock Exchange). The data also has information on the risk free rate of return rf t which is measured as the return on 30 day U.S. treasury Bills. From the list of industries, choose one industry that seems highly risky and one industry that seems relatively safe and pick one rm from each of these industries. First, for each selected rm estimate the parameter and in (3) by OLS. How do the estimates of dier? Does this accord with your expectations? (e) For each of the two rms you chose in part (d), test the hypothesis that the rms risk is the same as the average risk over the entire market. That is to say, test the null that = 1 against the two sided alternative. (f) For each of the two rms, test the implication of the CAPM derived in part (c) above against the two sided alternative. What is the sign of the in each (assuming it is non-zero) can be interpreted in an case. Note that the sign of i interesting way. In particular, note that from the OLS formula for the intercept
i = E (Rit rf t ) i E (RM t rf t ) > 0, this can be interpreted to indicate that it is yielding an If the rm has a i excess expected return6 higher than that predicted by the CAPM. The CAPM would predict that this stock is underpriced because its expected excess return is higher than predicted by CAPM. For each of the two rms you selected above, test the CAPM and report whether either is under- or over-priced according to the CAPM.

(g) Finally, recall the variance decomposition formula for the OLS model Var (Rit rf t ) = Var (i (RM t rf t )) + Var ( it ) The variance of the asset i is thus decomposed into two parts, the rst one is referred to as systematic (or market risk) while the second part is referred to as unsystematic risk because it is uncorrelated with the market risk. Therefore, the R2 of this regression is the fraction of the assets risk that is systematic risk. For each of the two companies, compute the proportion of the total risk that is market risk. Are the results in accord with your expectations?
The companies and Industries are as follows: Oil: Mobil, Texaco; Computers (IBM, DEC, DataGen); Electric Utilities (ConEd, PSNH); Forest Products (Weyerhauser, Boise); Airlines (PanAm, Delta); Banks (Contil, Citicorp); Foods (Gerber, GenMil). The variable ncomp in the le capm3.dta runs from 1 to 15 and identies the company in each observation. You can use the qualier if in STATA to restrict your calculations to particular rms (i.e. reg y x if ncomp==3) and you can list the values of ncomp using the STATA command label list ncomp. Use the command describe to view the description of the variables. 6 The expression E (Rit ) rf is often called the expected excess return.
5