CHAPTER 4: ANSWER KEY

Case Exercises
1. Estimating Betas

a. We run the regression of each of these stocks in turn against the market excess returns ESP1,
and we get the following output:

. regress APPLE ESP

Source | SS df MS Number of obs = 132

-------------+------------------------------ F( 1, 130) = 41.19
Model | 5446.491 1 5446.491 Prob > F = 0.0000
Residual | 17191.3966 130 132.241512 R-squared = 0.2406
-------------+------------------------------ Adj R-squared = 0.2348
Total | 22637.8876 131 172.808302 Root MSE = 11.5

------------------------------------------------------------------------------
APPLE | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
ESP | 1.470717 .2291684 6.42 0.000 1.017335 1.9241
_cons | .3080551 1.012654 0.30 0.761 -1.695361 2.311471
------------------------------------------------------------------------------

. regress IBM ESP

Source | SS df MS Number of obs = 132

-------------+------------------------------ F( 1, 130) = 38.43
Model | 1421.02595 1 1421.02595 Prob > F = 0.0000
Residual | 4807.50645 130 36.9808188 R-squared = 0.2281
-------------+------------------------------ Adj R-squared = 0.2222
Total | 6228.5324 131 47.5460488 Root MSE = 6.0812

1
In the text example we use a different portfolio to represent “the market.” One problem with
implementing CAPM is that it is not clear what should be considered as the market portfolio, since an
investor should really think about all his or her assets when assessing risk. Those assets could include, for
example, real estate, or even human capital (such as you are presently acquiring!).
------------------------------------------------------------------------------
IBM | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
ESP | .7512281 .1211879 6.20 0.000 .5114724 .9909838
_cons | -.8345361 .5355076 -1.56 0.122 -1.893974 .2249017
------------------------------------------------------------------------------

. regress HP ESP

Source | SS df MS Number of obs = 132

-------------+------------------------------ F( 1, 130) = 115.02
Model | 5338.44692 1 5338.44692 Prob > F = 0.0000
Residual | 6033.56125 130 46.4120096 R-squared = 0.4694
-------------+------------------------------ Adj R-squared = 0.4654
Total | 11372.0082 131 86.8092227 Root MSE = 6.8126

------------------------------------------------------------------------------
HP | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
ESP | 1.456057 .1357644 10.72 0.000 1.187463 1.72465
_cons | -.3231696 .5999189 -0.54 0.591 -1.510037 .8636983
------------------------------------------------------------------------------

So, reading from the output, the estimated beta for Apple is 1.47, for IBM is 0.751, and for HP is
1.456.

If the excess return on the market next month is minus 20%, using the methodology described in
the chapter, the expected excess return on Apple would be: 1.47 (-20) = -29.4%
i.e., an expected excess return of minus 29.4%, while for IBM, the expected excess return would
be minus 15.02%, and for HP minus 29.12%. So Apple and HP seem to be much more sensitive
to the overall market than is IBM.

b. If you invest $10,000 in Apple, at the beginning of next month, then using the above and
assuming a risk-free rate of 0.25% you expect to gain $10,000*(expected excess return on Apple
+ risk-free rate) = $10,000*(-29.4% + 0.25%) = -$2,915. So you expect to lose $2,915.

3. Shore Realty Revisited

The relevant output is

. regress price sqfoot

Source | SS df MS Number of obs = 85

-------------+------------------------------ F( 1, 83) = 688.71
Model | 1.3787e+11 1 1.3787e+11 Prob > F = 0.0000
Residual | 1.6616e+10 83 200187226 R-squared = 0.8924
-------------+------------------------------ Adj R-squared = 0.8912
Total | 1.5449e+11 84 1.8391e+09 Root MSE = 14149

------------------------------------------------------------------------------
price | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
sqfoot | 134.638 5.130362 26.24 0.000 124.4339 144.8421
_cons | 4604.436 12415.8 0.37 0.712 -20090.1 29298.97
------------------------------------------------------------------------------

so our estimate of the coefficient on ‘sqfoot’ is b1 = 134.64 , and the (estimated) standard
deviation of this estimate is sb1 = 5.13. The sample size is 85, so the number of degrees of
freedom is 83. The 90% confidence interval is therefore given by substituting into the formula
b1 ± t.05,83 sb1, giving 134.64 ± 10.20.2 What this means is that we are 90% confident that if we
compare the price fetched for two homes one of which is (for example) 100 square feet larger
than the other, then on average the larger one will fetch between $12,444 and $14,484 more than
the smaller one. Of course “90% confident” has the usual meaning that we have followed a
procedure which will yield an interval containing the correct value 90% of the time.

To get the prediction and the confidence and prediction intervals from Stata, we first open the
Data Editor and enter 2600 in the 87th cell under the sqfoot column. Next we click User>Core
Statistics>Predict, using most recent regression (confint) or type db confint. Now when we
click OK, Stata produces the following output:

price sqfoot predicted se_est_mean se_ind_pred CIlow CIhigh PIlow PIhigh

2600 354663.3 1841.785 14268.13 351000.1 358326.6 326284.6 383042

2
Note that we can also have Stata directly calculate this confidence interval by typing the direct command
regress price sqfoot, level(90). The reported confidence interval should be (126.1041, 143.172); the
discrepancy between Stata’s output and our manual calculation is due to rounding.
Thus the predicted selling price for a home with 2600 square feet is $354,663 and the CI and PI
are as given. The meaning of this CI is that we can have 95% confidence that the true mean
selling price for homes of that size is between $351,000 and $358,327, i.e., to produce those
numbers we followed a procedure which 95% of the time produces intervals that do indeed
contain the true mean. The PI means that we can have 95% confidence, in the same sense that the
selling price of a randomly picked home of size 2600 square feet will lie between $326,285 and
$383,042. Another way of looking at this is that we are predicting that, if we look at the prices of
all houses of that size, the middle 95% will lie between $326,285 and $383,042 suggesting that
about 2.5% will sell for over $383,042.

Problems
1.
. regress percent_chginRetailSales percent_chginGDP

Source | SS df MS Number of obs = 10

-------------+------------------------------ F( 1, 8) = 2.89
Model | 7.40114613 1 7.40114613 Prob > F = 0.1278
Residual | 20.5188573 8 2.56485716 R-squared = 0.2651
-------------+------------------------------ Adj R-squared = 0.1732
Total | 27.9200034 9 3.1022226 Root MSE = 1.6015

------------------------------------------------------------------------------
percent_chgin~Sales| Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
percent_chginGDP| .7306166 .4301022 1.70 0.128 -.2612008 1.722434
_cons | 3.425496 1.486748 2.30 0.050 -.0029515 6.853944
------------------------------------------------------------------------------

a. The Stata output above gives us a regression equation of:

percent_chginRetailSales = 3.4255 + 0.7306 · percent_chginGDP

b. The regression coefficient of 0.73 tells us that as GDP increases by one percent, retail sales will
increase by 0.73 percent.

c. To construct a 95 percent confidence interval manually, use the t-statistic 2.306 (=invttail(8,
0.025)) and the standard error of the coefficient 0.4301: 0.7306 ± 2.306 · 0.4301 or [-0.26, 1.72 ].
Note that Stata automatically calculates this confidence interval and displays it in the regression
output above.

d. To construct a 90 percent confidence interval manually we need to derive the proper t-statistic.
Typing display invttail(8, 0.05) gives us the correct figure of 1.8595. The confidence interval is
just: 0.7306 ± 1.8595 · 0.4301 or [-0.069, 1.53]. To have Stata automatically calculate this
confidence interval, we can type the direct command regress percent_chginRetailSales
percent_chginGDP, level(90). Alternatively, we can set 90 as our confidence level under the
Reporting tab in the regress dialog box.

e. The p-value of 0.128 (or 12.8%) is greater than our α of 5% and so we must accept the null
hypothesis that the true coefficient is equal to zero. This may be the result of the small sample
size since it’s hard to establish proof of a non-zero coefficient with such little evidence.

2a. You can either plug 3.0 into the regression equation or use Stata’s prediction function as
below. The answer should be the same: 5.617%

percent_chginGDP percent_chginRetailSales predicted

3 -- 5.617346

b and c. Stata’s prediction function is very useful here:

Confidence level = 95%
PIlow PIhigh
1.736056 9.498635

Confidence level=98%
PIlow PIhigh
.7422469 10.49244

d. The prediction output tells us the relevant information. The percent_chginRetailSales follows
a t-distribution with 8 degrees of freedom. The mean is 5.617 and the standard deviation is 1.683
(the standard error of prediction, or se_ind_pred.) So, we can then use Stata to answer the
question typing display ttail(8, (8.5-5.617)/1.683) which gives us 0.0625.
 3. Overall, there is not much happening with this regression. The p-value is a little too high to
make us confident in the relationship between the two variables. Furthermore, the R-squared
value is also fairly low which tells us that the percent_chginGDP is not able to explain a lot of
the variance in the percent_chginRetailSales. Finally, a look at the scatterplot tells us that the
relationship is not very linear or strong. One data point (in the bottom left of the graph) seems to
have a strong pull on the line, a problem that we’ll analyze later on.

Scatterplot
10

8
% chg in Retail Sales

2
0 1 2 3 4
%chg in GDP

% chg in Retail Sales Fitted values

4a. The regression equation comes straight from this Stata output:

. regress Salary Years_Experience

Source | SS df MS Number of obs = 41

-------------+------------------------------ F( 1, 39) = 22.93
Model | 9.6890e+09 1 9.6890e+09 Prob > F = 0.0000
Residual | 1.6480e+10 39 422552823 R-squared = 0.3703
-------------+------------------------------ Adj R-squared = 0.3541
Total | 2.6169e+10 40 654214963 Root MSE = 20556

-------------------------------------------------------------------------------
-------------------------------------------------------------------------------
Salary | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+-----------------------------------------------------------------
Years_Experience| 1853.615 387.0969 4.79 0.000 1070.638 2636.592
_cons | 30256 7119.001 4.25 0.000 15856.46 44655.54
------------------=------------------------------------------------------------

Salary = 30256 + 1854 · Years_Experience

b. As Years_Experience increases by one, salary increases by an average of 1854.

c. To construct a 95 percent confidence interval manually, use the t-statistic of 2.0227

(=invttail(39, 0.025)) and the standard error of the coefficient 387: 1854 ± 2.0227 · 387 or [
1071, 2637 ]. Stata automatically calculates this confidence interval and displays it in the
regression output above.

d. To construct a 99 percent confidence interval we need to derive the proper t-statistic. Typing
display invttail(39, 0.005) gives us the correct figure of 2.708. The confidence interval is just:
1854 ± 2.708 · 387 or [806 , 2902]. To have Stata automatically calculate this confidence interval,
we can type the direct command regress Salary Years_Experience, level(99) and get (805.3902,
2901.84).

e. The p-value of 0.000 is lower than α=0.05 and so we reject the null hypothesis and conclude
that the true slope is not zero.

5. Stata’s prediction (confint) command gives us everything we need for this question:
User>Core Statistics>Prediction, using most recent regression (confint)
Salary Years_Experience predicted se_est_mean se_ind_pred CIlow CIhigh PIlow PIhigh
-- 9 46938.54 4306.288 21002.31 38228.25 55648.83 4457.36 89419.72

a. The expected salary for a worker with nine years experience is 46,938.54

b & c. The last two columns of prediction output in the Data Browser/Editor gives us the answers
to parts b and c.
Confidence level=95%
PIlow PIhigh
4457.36 89419.72

Confidence level=75%
PIlow PIhigh
22413.23 71463.84

d. This question asks us for a confidence interval which we can generate by using Stata’s
prediction (confint) command and setting the confidence level at 90%:
CIlow CIhigh
39682.98 54194.1

e. The p-value of 0.000 tells us that work experience is indeed significantly related to salary.

6. The R-squared statistic of 0.3703 tells us that 37.03% of the variance in salary can be
explained by the level of work experience. This number seems reasonable. Certainly there are
other things that impact salary which is why there is still 100- 37 or 63% left unexplained. But
work experience certainly does matter somewhat and 37% doesn’t seem too high or to low to be
sensible.

7: See the table below for the answers to problem 7

Belgium Denmark
a. Regression Equation WG = 11.65 - 0.73 Un Rate WG = 11.80 - 0.83 Un Rate
b. Effect of 1% increase -0.73 -0.83
in unemployment
c. 95% CI for coef. -0.73 +/- 2.0211*(0.16) -0.83 +/- 2.0211*(0.20)
d. Pred Growth Rate at 3% 9.45 9.32
e. 90% CI for part d. 9.45 +/- 1.68*(3.45) 9.32 +/- 1.68*(3.53)

8: See the table below for the answers to problem 8

Germany Greece
a. Regression Equation WG = 9.88 - 0.94 Un Rate WG = 20.35 - 1.07 Un Rate
b. Effect of 1% increase -0.94 -1.07
in unemployment
c. 95% CI for coef. -0.94 +/- 2.0211*(0.11) -1.07 +/- 2.0211*(0.30)
d. Pred Growth Rate at 3% 7.07 17.14
e. 90% CI for part d. 7.07 +/- 1.68*(2.14) 17.14 +/- 1.68*(5.70)
9: See the table below for the answers to problem 9

Spain France
a. Regression Equation WG = 17.83 - 0.65 Un Rate WG = 13.91 - 0.89 Un Rate
b. Effect of 1% increase -0.65 -0.89
in unemployment
c. 95% CI for coef. -0.65 +/- 2.0211*(0.11) -0.89 +/- 2.0211*(0.15)
d. Pred Growth Rate at 3% 15.88 11.24
e. 90% CI for part d. 15.88 +/- 1.68*(4.95) 11.24 +/- 1.68*(3.72)