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In-Class Exercises and Examples: February 20

Multiple Regressions Part 1

This in-class exercise is designed to illustrate objectives of todays session:
Derive OLS Estimates of Multiple Regression Models in Eviews
Variable Selection in Multiple Regression Models

1. Capital Asset Pricing Model (CAPM2.XLS)
The history on CRSP (Center for Research in Security Prices):
Louis Engel, vice president at the firm then known as Merrill Lynch, Pierce, Fenner &
Smith, in 1959, inquired of Professor James H. Lorie (Ph.D. 1947; Associate Dean 1956;
Professor of Business Administration) as to whether investment performance in the stock market
relative to other types of investments had been analyzed. Such an analysis was not feasible as no
comprehensive stock market database was available at the time. Professor Lorie proposed that
Merrill Lynch provide funds for a project with the purpose of constructing the stock database.
The work would involve gathering, cleaning, and including the prices, dividends, and rates of
return of all stocks listed and trading on the NYSE since 1926. The work would also include
calculating rates of returns for those same stocks. Thus with a grant of $ 300,000 from Merrill
Lynch, the Center for Research in Security Prices (CRSP) was established in 1960.
Equity risk premium:
In 1974, Ibbotson and Sinquefield presented their estimates of the risk premium. When it
was added to the government bond rate, they forecasted (scientifically) that at the end of 1998
the DWI would hit 9218 and 10,000 by November 1999. Remember DWI was in 800s at that
time. What happened? By the end of 1998, DWI reached 9,181, and in March 1999, it reached
10,000.
We will use the return rate on three industries: food, construction, and durables to
estimate the CAPM. The file capm2 contains stock market data from January 1960 to December
2002 (T=516). All (excess) returns are in % per month. Stock portfolios are selected using a
classification of industries based on the 4-digit SIC code (which distinguishes 17 different
industries).


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The following variables are available: rfood rdur rcon rmrf rf jandum

rfood: excess returns food industry
rdur: excess returns durables industry
rcon: excess returns construction industry
rmrf: excess returns market portfolio
rf: riskfree return

Please answer the following questions:

1. Test whether on average the excess return is the same between the food and durable
goods industries at 5% significance level; what about between food and construction, or between
construction and durable goods industries at 5% significance level?
2. Estimate an OLS regression in Eviews for each of the three industries with an intercept
(i.e. constant term). Present your output in the normal form.
3. Interpret the meaning of intercept and the coefficient. Test the null hypothesis that the
constant term = 0 and = 1 for each of the three industries at 5% significance level.
4. Interpret the meaning of R
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for each industry. Please avoid using the generic
interpretation (i.e. x percent of variation of dependent variable can be explained by the model.)
5. If rmrf = 10%, predict the excess return in durable goods industry. Use SEE and SEF
to construct its 95% confidence interval.
6. Check the autocorrelation of the error term for the three industries. Is autocorrelation a
problem?


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2. The Pie Example (pie sales example.xls)
We use the data pie sales example.xls as an example to illustrate multiple regressions
in Eviews. It is a very simple data. We mainly use it for illustration purpose. We will see more
realistic examples latter.
In this example, a Boston based Food Company, produces deluxe frozen fruit pies that
are low in fat and sugar. The companys market research department is conducting a survey on
the sale and potential demand for selected metropolitan areas and needs your help in identifying
the factors they should look into. Results of your research can be used in sales forecasting and
discovery of potential markets.
1. If you are assigned this project, what is the first thing you should do? According to
microeconomic theory, what variables should be included in the model?
2. Derive OLS estimates by using Quick Estimate Equation. Present the results in
a NORMAL form. And interpret the coefficient estimates.
3. Conduct critical-value and p-value tests for the coefficients. Find an efficient way to
present your results for the purpose of variable selection and model comparison.
4. Use within-sample forecasting to evaluate the full model and the model without
population and advertising variables. How would you create the 95% confidence interval for
your forecasts?
5. Use pseudo out-of-sample forecasting to evaluate the full model (please use the first 40
observations for model building).
6. In the full model, is own price effect statistically different cross price effect?
7. Are the effects of own price, competitors price and income jointly significant in
explaining variations in sales?
8. Forecast sales when Px = 550 cents; Pc = 450 cents; Ax = $6; I = $40; and Pop =
2,600. And construct the 95% confidence interval based on SER and SEF.
9. Check the autocorrelation of the residuals. Is autocorrelation a problem?