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Home Solutions (a) Under what conditions is the use of Ordinary Least Squares appropriate? [7 marks]

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FR2202 Financial Econometrics

SECTION A – COMPULSORY SECTION

Question 1

(a) Under what conditions is the use of Ordinary Least Squares appropriate? [7 marks]

(b) Explain the notion of market efficiency by referring to return autocorrelation. [7 marks]

(c) What are the consequences of serial correlation in the residuals and what are the remedies for this type of misspecification? [7 marks]

(d) Discuss the causes of heteroscedasticity in the context of financial data. [7 marks]

(e) Discuss the concept of a random walk with drift. [7 marks]

SECTION B – ANSWER ONE QUESTION FROM THIS SECTION

Question 2

The following models were fitted to a cross-sectional dataset of 50 firms: (0.052) (1.243) (0.015) (1.324) 2.3 0.2 6.14 0.01 1.5 0.40 60 (1) 2 y = + x1 − x2 − x3 + x4 R = RSS = Model (0.42) (2.98) 2.6 0.25 6.14 0.30 70 (2) 2 y = + x1 − x2 R = RSS = Model where y = rate of return on equity for the firm (ROE), x1 = market share, x2 = measure of firm size, x3 = industrial growth rate, x4 = level of world trade in industrial products. Numbers in parentheses are coefficient standard errors.

(a) Use Model (1) to test whether the variables are significant the 5% level. Comment on the estimated coefficients. [7 marks]

(b) Based on models 1 and 2, examine the joint hypothesis that the coefficients on x3 and x4 are both equal to zero. Note: F(2,45) at 5% level is 3.20. [8 marks]

(c) Explain how you would test whether financial firms have on average higher ROE. [7 marks]

(d) Explain how you would test whether the impact of size on ROE is greater for financial firms.

Including Question 3 till Question 5