BES Tutorial Sample Solutions, S2, 201010

WEEK 11 TUTORIAL EXERCISES (To be discussed in the week starting

October 4)

1. Useacalculator tocomputethesampleleastsquaresregressionlinefor
themodel
,giventhefollowingsixobservations.

y 2 8 6 12 9
11
x 1 4 3 10 10 8
1 4 3 10 10 8
2 8 6 12 9 11
6;
8
6
6
1 6 2 8
8 6 11 8 62
1

Thusthesampleregressionlineis

0.8378
2.9732

74

62
0.8378
74
6 2.9732
0.8378

2. Suppose the relationship between the dependent variable weekly

household consumption expenditure in dollars (y) and the independent
variable weekly household income in dollars (x) is represented by the
simpleregressionmodel(ireferstotheithobservationorhousehold):

Supposeasampleofobservationsyieldsleastsquaresestimatesof
b0=32andb1=0.82.

(a) Whatdoes representinthemodel?
1

It is the random disturbance term. It includes any purely random factors or

errorsandfactorsthathavebeenleftoutofthemodelbutwhoseinfluenceis
consideredminor.

(b) State the basic (classical) assumptions made about the s in this
model.Explaininwordswhattheassumptionsmean.

|
(i)
0forallobservations.Theconditionalmeanofthedisturbance
doesnotdependonxandisnormalizedtozero.Notethisisdifferentfrom
Kellerwhoonlymentionsthenormalizationtozero.Thattheconditional
mean of the disturbances does not depend on x ensures unbiasedness of
theOLSestimatorandsoisthemuchmoreimportantcomponentofthis
assumption. Relating back to the previous part of the question it implies
that omitted factors that might affect expenditure but appear in the
disturbanceareassumedtobeuncorrelatedwithx.
(ii)
, aredrawnbysimplerandomsamplingandhenceiid.
(iii) Thestandarddeviationof isconstantforallobservations.Itisdenoted
by and we say the disturbances are homoskedastic. Here that implies
the variability in food expenditure does not depend on income which is
possiblyproblematicinpractice.
(iv) The disturbances for any two observations are independent. This will
imply, in particular that there is no correlation between disturbances
associated with different observations. In this example the factors in the
disturbanceforhouseholdiarenotcorrelatedwiththoseforhouseholdj.
(v) isnormallydistributedforallobservations.

Doestheestimateofb0=32makesense?Ifnot,doesthisnecessarily
invalidatethemodel?Explainyouranswer.

Thisindicatesthatifahouseholdhadazeroweeklyincomethenonaverage
such a household would have negative consumption, which does not make
sense.However,thisdoesnotnecessarilyinvalidatethemodel.Itmaybethat
the linear model is only a reasonable approximation for some range of
household incomes, not including incomes near zero. In particular, the
relationship may be nonlinear for values of x near zero. The conclusion is
thatweshouldbecarefulininterpretingtheinterceptterm,asitmaynotbe
verymeaningfulinsomecases.

(c)

Interpretboth 1andb1.Whatdoesthemodelpredictwouldbethe
changeinyfollowinga$10increaseinxfromsomeinitiallevel?

1isthe(unknown)populationchangeinthevalueofyresultingfromaone
unit increase in x, whereas b1=0.82 is an estimate of 1. In this particular

examplethisisthemarginalpropensitytoconsumethatwouldbediscussedin
economics courses. The predicted change in y following a $10 increase in x
wouldbe10
10 0.82 $8.20.

(d) Suppose we measured y and x in cents rather than dollars. What

effectwouldthishaveontheestimatedcoefficientofx?Whateffect
wouldithaveontheestimatedintercept?
Inthiscase:$xbecomes100xcentsand$ybecomes100ycents.Theestimated
coefficientof xi whenthevariablesaremeasuredindollarsisgivenby

Ifwelet betheestimatedslopecoefficientwhenthevariablesaremeasured
incents,wehave
100
100 100
100 100

100
100
100

Also,denoteby theestimatedinterceptinthiscasethenwehave

100
100
100
100

Thusestimationofthismodel(withthesame,butrescaleddata)wouldlead
3200.
toanunchangedb1,whilsttheintercepttermwouldbecome100

(e) Supposeyweremeasuredindollarsbutxweremeasuredincents.
Whateffectswouldthishaveontheestimatedcoefficientofx?

Denotetheestimatedslopeandinterceptinthiscasebylet and .Then

100
100
100

100
100
100
100

100


Now estimation of this model would lead to the estimated coefficient of the
income variable being 0.0082 and estimated intercept would be unchanged.
Thismakessensesince:
If income is measured in dollars, we predict expenditure (in dollars) will
increaseby$0.82ifhouseholdincomeincreasesbyonedollar.
If income is measured in cents, we predict expenditure (in dollars) will
increaseby$0.0082ifhouseholdincomeincreasesbyonecent.

(f) Distinguish between and (or , the residual associated with

observationi).Illustrateyouranswerwithadiagram

We can think of
as an estimate of the true random disturbance
.
associatedwithobservationi,

3. ComputingExercise#4
Refer to the Computing Work document in Course Documents in the
Blackboardwebsite.Answerthe2questionsassociatedwithsimplelinear
regressiononpages21and22.

As indicated below in the Line fit plot produced for the first part of the
question,thereisapositivecorrelationbetweenthereturnsonIntelstockand
theoverallmarketreturn.Howeverthereisconsiderablevariationaroundthe
superimposedlinearrelationship.

Discussion:
i)
Whatisthesampleregressionline?
FromtheExcelregressionoutputbelow:

0.022 1.472 ,

ii) Istheresufficientevidencetoinferatthe5%significancelevelthat
thereisalinearrelationshipbetweenthereturnonIntel
Corporationstockandthereturnonthetotalmarket?
Appropriatehypothesistobetestedis:

:
0; :
0

whichaccordingtotheExceloutputyieldsapvalueof0.0069andsoforany
significancelevelgreaterthan0.0069(whichincludes5%)wewouldreject
thenullandconcludethereisevidencetosuggestalinearrelationship.

iii) Istheresufficientevidencetoinferatthe5%significancelevelthat
IntelCorporationstockismoresensitivethantheaveragestock?
Nowtheappropriatehypothesistobetestedis:

:
1; :
1

Thestandardizedteststatisticforthishypothesisis:

1.47163 1
0.9061
0.52052

Usingatcriticalvalueand40degreesoffreedom(actually47degreesof
freedombutthisvaluenotintables)yieldsarejectionregionoft>1.684.
AlternativelywitharelativelylargesamplesizewecaninvoketheCLTanduse
the5%normalcriticalvalueof1.675.

Ineithercasethecalculatedteststatisticfallswellshortoftherejection
regionandwecannotrejectthenullhypothesis.

iv) Discussthesignificanceofthefindings?
Whilethereisevidenceofastrongpositiverelationshipbetweenthereturns,
theevidenceofwhethertheIntelstockismoreorlesssensitivetothemarketis
5

weak.Thepointestimateof1.472indicatesevidenceinfavourofbeingmore
sensitivebutwecannotexcludethepossibilitythatitisinfactlesssensitive.
The95%CIprovidedbyExcelis(0.424,2.519)andhenceincludesvalues
consistentwithbothpossibilities.

v)
Explainthemeaningoftheregressionandresidualsumofsquares.
The total sums of squares representing the total variation (0.4446) in the
dependent variable (returns on Intel stocks) can be decomposed into two
parts:aregressionsumofsquares(0.0658)representingthatpartexplained
bytheregressionmodelandtheresidualsumofsquares(0.3788)representing
thatpartleftoverandunexplainedbythemodel.Inthiscasethelatterislarge
relativetotheformerleadingtoanR2of0.148indicatingthatonly14.8%of
thevariationinIntelstockisbeingexplainedbythemarketmodel.

Thisisconsistentwithourinitialobservationfromthescatterplotthatthere
wasconsiderablevariationaroundthetrendline.Seealsothelinefitplotthat
overlaystheestimatedmarketmodelonthebivariatescatter.
SUMMARY OUTPUT
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations

0.3848
0.1480
0.1295
0.0907
48

ANOVA
df
Regression
Residual
Total

Intercept
INDEX

1
46
47
Coefficients
0.02192
1.47163

SS
MS
0.065822161 0.065822
0.378800255 0.008235
0.444622416
Standard Error
0.01508
0.52052

t Stat
1.45365
2.82722

Significance F
F
7.993182 0.0069287

P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%

0.15283
-0.00843
0.05228
-0.00843
0.05228
0.00693
0.42387
2.51938
0.42387
2.51938

INDEXLineFitPlot
0.25
0.20
0.15
0.10
INTEL

0.05

0.1

INTEL

0.00
0.05

0.05 0

0.05

0.1

PredictedINTEL

0.10
0.15
0.20
INDEX