ECON 7310: ELEMENTS OF ECONOMETRICS Dr. Dong-Hyuk Kim Research Project 1, Due date 10th April Background You are a budding econometrician equipped only with very rudimentary econometrics knowledge and a working knowledge of the simple regression model. You are entrusted with the analysis of some financial data (share prices) and asked to estimate the Capital Asset Pricing Model (CAPM) given in equation (1) below to assess the performance of selected Australian companies. In particular you focus on two aspects: (i) whether a particular stock beats the market in terms of returns; and (ii) whether the stock is riskier than the average market (like the ASX200) in terms of returns. Data The file ozdatm.xls contains monthly data for 10 years labelled 1 to 120. The data series include: 1. Share price values for several Australian companies 2. TBILL rate: 3, 5 and 10 yr Bond Rates, 3. ASX200 The ASX200 series represents a market portfolio and the Treasury Bill (TBILL) rates provide three different riskfree assets. You have decided to analyse share price data from NAB, Coles Myers and two other companies of your choice. Basic Model As you have a limited understanding of financial data and analysis, you have decided to consult a standard introductory textbook like that by Brooks (2014), Introductory Econometrics for Finance (3rd edition), Cambridge University Press. You find that the following formula is used in computing returns from share price data. If pt is the share price of a particular company at time t, then a simple measure of return, Rt, is computed as: Rt = pt − pt−1 pt = 1 − pt−1 pt In the book you find that the relationship between the monthly returns on the share value of these companies can be explained by the excess return CAPM relationship: Rjt − Rft = αj + βj(Rmt − Rft) (1) where Rjt are returns of asset j at time t, Rft are riskfree returns at time t, Rmt are market portfolio returns at time t, and (Rjt − Rft) and (Rmt − Rft) are excess returns. In order to examine the performance of the stocks you have selected, you need to estimate the relationship in (1) for each stock j or the stock you have selected. From the introductory textbook you understand that a significant and positive intercept means that the particular stock beats the market and a value of the slope which is significantly higher than 1 implies that the particular stock is riskier than the market. 1Analysis You need to undertake the steps below in performing your analysis and prepare a report on the performance of the stocks. 1. Graph the share prices and returns from the share prices of selected stocks and also for ASX200. Comment on the graphs in terms of the trends and any intuition about the performance of the stocks. (10 marks) 2. The CAPM model in (1) is deterministic. Write a suitable econometric or regression model for (1). (2 marks) 3. Clearly state your assumptions for the model and explain what each assumption makes. (5 marks) 4. What estimation technique do you choose and explain why it is the best procedure to use? (3 marks) 5. To estimate the parameters in the model you must choose suitable proxies for the riskfree return and the market portfolio from those available in the data set. Justify your choice. (5 marks) 6. Present the estimated CAPM model for all the stocks you have selected. Discuss the main features of the estimated models in terms the meaning and significance of the estimated coefficients. (10 marks) 7. Conduct tests necessary to assess the performance of the stocks you have selected. Clearly state the null and alternative hypotheses and the test procedures conducted and present conclusions from these tests. (20 marks) 8. Discuss the adequacy of the CAPM model using appropriate indicators from your Stata output. (5 marks) 9. Are the disturbances in your model normally distributed? Justify. (5 marks) 10. In addition to the steps above, you may conduct any other type of analysis that you may consider useful. This is the part that represents your originality. (10 marks) In addition, Write a short report summarizing your approach and findings on the performance of the companies you have selected. (25 marks) Make sure that you present: 1. CAPM Model estimated 2. Econometric Results (mention which diagnostics tests did you check and what conclusions did you reach) 3. Conclusions written for the non-specialist. About the Report to be submitted: • Length of the report should be up to a maximum of 8 type-written pages in one-and-half spacing excluding the Appendix with Stata output (or output from your selected econometric package like EViews or R. • You should copy and paste relevant parts of Stata output into the report. • Attach your Stata output in the Appendix. • Submit your report to the Faculty Collaborative Research Centre by the due date. 2