Assignment 1: Modelling Financial Relationships
This is an individual assignment.
Task: to estimate the excess returns on a stock of your choice applying the Arbitrage Pricing Theory (APT).
Aim: to evaluate your understanding of financial theory to transform data into correct form, to model financial relationships and correctly interpret the findings. The analysis of the results is the most important stage of the assignment. It involves estimating an initial model or models, performing appropriate diagnostic tests, re-forming and re-estimating, and conducting tests of hypothesis.
Format: The assignment consists of three parts comprising a written report of a maximum of 1,500 words.
Specific instructions on performing the task:
PART 1: (25 marks)
1. Carefully explain the APT, outlining the mathematical model, underpinning it,
appropriately referenced. [8 marks]
2. Discuss, with reference to an empirical study, the applicability of APT for estimating excess stock returns. Note that there are no limitations on the year of the publication. It can be a more recent study or a seminal work, but not the example discussed in class. [8 marks]
3. Briefly, provide a background information on your chosen company. [2 marks]
4. Present and explain the model you will be estimating based on the APT, in the context of your data. Your model should be of the form:
Yt = + β1X1t + β2X2t + ut ut ~ N (0, σ2) [7 marks]
PART 2: (30 marks)
1. Collect monthly data, for a five-year period, with reference to the relevant sources, on:
a) the prices for your chosen stock
b) the corresponding market index prices
c) the relevant risk-free asset returns
d) a macroeconomic indicator of your choice
Relevant data is available from: Yahoo Finance, FRED (The Federal Reserve Bank of St. Louis), Kenneth R. French Data Library, IMF, and the World Bank.
[6 marks]
2. Compile an Excel worksheet and import the data into EViews. [1 mark]
3. Make the necessary data transformations. [10 marks]
4. Test the variables for unit-root; carefully formulate the hypothesis and make a correction, if possible. [6 marks]
5. Investigate the variables included in your model. Present in a table and briefly interpret the respective summary statistics. Include two scatter plots of relevant variables.[7 marks]
PART 3: (35 marks)
1. Estimate the model and test if it conforms to three of the classical OLS assumptions for the residuals: homoscedasticity; no series correlation and normality. You are required to make any corrections that are possible. [10 marks]
2. Carefully specify the hypotheses for testing the assumptions on the residuals, the
individual coefficients and the F-test for overall significance. [8 marks]
3. Correctly interpret the estimated coefficients in terms of their signs, significance and impact on the dependent variable. [6 marks]
4. Correctly interpret the R2 and the F-statistic. [6 marks]
5. Briefly compare your findings with the article surveyed in Part 1. [5 marks]
Structure: The three parts, with the detailed instructions, should provide the structure of your report. [2 marks]
