Last Revised: 07/25/2023

2024 Level 2 - Quantitative Methods

Learning Modules Page

Basics of Multiple Regression and Underlying Assumptions 2

Evaluating Regression Model Fit and Interpreting Model Results 6

Model Misspecification 11

Extensions of Multiple Regression 16

Time-Series Analysis 23

Machine Learning 32

Big Data Projects 43

Review 50

M.M134813896.

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 Last Revised: 07/25/2023

Basics of Multiple Regression and Underlying Assumptions

a. describe the types of investment problems addressed by multiple linear regression

and the regression process

b. formulate a multiple linear regression model, describe the relation between the
dependent variable and several independent variables, and interpret estimated
regression coefficients

c. explain the assumptions underlying a multiple linear regression model and

interpret residual plots indicating potential violations of these assumptions

M.M134813896.

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Basics of Multiple Regression

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specify the model
Main tasks
interpret the output

Multiple regression used to:

identify relationships between variables
test existing theories
forecast value of a DV

- model:

𝐘𝐢 = 𝐛𝟎 + 𝐛𝟏 𝐗 𝟏𝐢 + 𝐛𝟐 𝐗 𝟐𝐢 + ⋯ + 𝐛𝐊 𝐗 𝐊 𝐢 + 𝛆𝐢 𝐢 = 1 ➞ n
deterministic part n > 𝐤
intercept
𝐤 IVs or slope Stochastic
coefficients part
- partial slope coefficients
%𝐛 ➞ estimated

* Describe the types of investment problems addressed by multiple linear regression and the regression process

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partial slope coefficient: measures ∆DV for a 1 unit ∆IV holding
all other IVs constant
e.g./ RET = .0023 - 5.0585 BY - 2.1901 CS

return bond yield credit spread

when both IVs = 0, RET = .0023
BY ↑ 1, RET ↓ 5.0585
CS ↓ 1, RET ↑ 2.1901
Assumptions/ M.M134813896.

1/ Linearity - relationship between the DV and IVs are linear

2/ Homoskedasticity - the variance of the regression residuals is
the same for all observations i.e. 𝐕𝐚𝐫(𝛆𝐢 ) = 𝐕𝐚𝐫.𝛆𝐣 /

* Formulate a multiple linear regression model, describe the relation between the dependent variable and several independent variables, and interpret estimated regression coefficients

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Assumptions/
3/ Independence of errors - the observations are independent of
one another
∴ regression residuals are uncorrelated across observations
4/ Normality - regression residuals are normally distributed
5/ Independence of IVs
1/ IVs are not random (i.e. - they have a specific value)
2/ no exact linear relationship between 2 or more IVs
Scatterplot matrix (pairs plot)
- uses simple linear regression: DV vs. each IV
+ each IV vs. the other IVs
what to see
don’t want to see
linear relationships
linear relationships
* Explain the assumptions underlying a multiple linear regression model and interpret residual plots indicating potential violations of these assumptions

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Scatterplot Matrix
since we can, and will, interpret
slight pos. relationship output ➞ this is not a very useful
step
- any violations will be identified
statistically, not visually

DV
IVs
pos. linear neg. linear
M.M134813896.

almost no ‘apparent’
➞ 𝐛𝐒𝐌𝐁 is sig. in the output however
linear relationship

* Explain the assumptions underlying a multiple linear regression model and interpret residual plots indicating potential violations of these assumptions

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 Last Revised: 07/25/2023

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- helps identify outliers

- helps visually assess

homoskedasticity

dispersion appears fairly constant

and random

non-constant correlated errors

variance (autocorrelation)

* Explain the assumptions underlying a multiple linear regression model and interpret residual plots indicating potential violations of these assumptions

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standardized residuals vs. normal distribution
- outliers
affect outlier
parameter value of 𝛆
values 5%
𝛆𝐢 − 𝛆1
directional 𝛔𝛆
relationship
= misspecified
model
5% Q-Q plot
corr(IV, 𝛆)
outliers
M.M134813896.
-1.65 +1.65
Z score
- normally distributed 𝛆 should
fall on the vertical line

* Explain the assumptions underlying a multiple linear regression model and interpret residual plots indicating potential violations of these assumptions

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Evaluating Regression Model Fit and Interpreting Model Results

a. evaluate how well a multiple regression model explains the dependent variable by
analyzing ANOVA table results and measures of goodness of fit

b. formulate hypotheses on the significance of two or more coefficients in a multiple

regression model and interpret the results of the joint hypothesis tests

c. calculate and interpret a predicted value for the dependent variable, given the
estimated regression model and assumed values for the independent variable

M.M134813896.

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Evaluating Model Fit/Interpreting Results

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Coefficient of Determination ➞ 𝐑𝟐 explained predicted
𝐬𝐮𝐦 𝐨𝐟 𝐬𝐪𝐮𝐚𝐫𝐞𝐬 𝐫𝐞𝐠𝐫𝐞𝐬𝐬𝐢𝐨𝐧 ∑.𝐘 @/𝟐
%𝐢 − 𝐘
= =
𝐬𝐮𝐦 𝐨𝐟 𝐬𝐪𝐮𝐚𝐫𝐞𝐬 𝐭𝐨𝐭𝐚𝐥 @)𝟐
∑(𝐘𝐢 − 𝐘
average
observed
as IVs are added, 𝐑𝟐 will increase or stay the same
- never decreases
no information on coefficient significance
no information on regression violations that may cause
coefficients to be biased
poor gauge of model fit - overfitting creates a bad model
- low in-sample error, high
out-of-sample error

$ 𝟐 = 1 - 𝐒𝐒𝐄/𝐧 − 𝐤 − 𝟏
Adjusted 𝐑𝟐 ➞ 𝐑 𝐧−𝟏
= 𝟏 − IJ K (𝟏 − 𝐑𝟐 )L
𝐒𝐒𝐓/𝐧 − 𝟏 𝐧−𝐤−𝟏

* Evaluate how well a multiple regression model explains the dependent variable by analyzing ANOVA table results and measures of goodness of fit

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Adjusted 𝐑 ➞ 𝐑 𝟐 $𝟐 = 1 - 𝐒𝐒𝐄/𝐧 − 𝐤 − 𝟏 𝐧−𝟏
= 𝟏 − IJ K (𝟏 − 𝐑𝟐 )L
𝐒𝐒𝐓/𝐧 − 𝟏 𝐧−𝐤−𝟏
FYI 𝐒𝐒𝐄 𝐧−𝟏
× 𝐒𝐒𝐄(𝐧 − 𝟏) 𝐧−𝟏 𝐒𝐒𝐄
𝐧−𝐤−𝟏 𝐒𝐒𝐓
= =- .- .
𝐒𝐒𝐓 𝐧−𝟏 𝐒𝐒𝐓(𝐧 − 𝐤 − 𝟏) 𝐧 − 𝐤 − 𝟏 𝐒𝐒𝐓
×
𝐧−𝟏 𝐒𝐒𝐓

➞ SSR + SSE = SST ➞ 𝐒𝐒𝐑D𝐒𝐒𝐓 + 𝐒𝐒𝐄D𝐒𝐒𝐓 = 1

𝐑𝟐 + 𝐒𝐒𝐄D𝐒𝐒𝐓 = 1
M.M134813896.

∴ 𝐒𝐒𝐄D𝐒𝐒𝐓 = 1 - 𝐑𝟐
" 𝟐 : if 𝐤 ≥ 𝟏 , 𝐑
- for 𝐑 " 𝟐 < 𝐑𝟐
" 𝟐 ↑ , else 𝐑
& if coefficient’s |𝐭 − 𝐬𝐭𝐚𝐭| > 𝟏 , 𝐑 "𝟐 ↓

* Evaluate how well a multiple regression model explains the dependent variable by analyzing ANOVA table results and measures of goodness of fit

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application/
𝐒𝐒𝐑 𝟗𝟎. 𝟔𝟐𝟑𝟒
𝐑𝟐 = = = . 𝟔𝟏𝟓𝟓
𝐒𝐒𝐓 𝟏𝟒𝟕. 𝟐𝟒𝟏𝟔
𝟓𝟎 − 𝟏
@ 𝟐 = 𝟏 − IJ
𝐑 K (𝟏 − . 𝟔𝟏𝟓𝟓)L
𝟓𝟎 − 𝟓 − 𝟏
= . 𝟓𝟕𝟏𝟖

$ 𝟐 ↑ with Factor 1, 3, 4
𝐑
$ 𝟐 ↓ with Factor 2 & 5
𝐑
also
insignificant
F1 + F2 : 𝐑
@ 𝟐 ↓ , add F3 : 𝐑
@ 𝟐 ↑ , Add F4 : 𝐑
@ 𝟐 ↑ , Add F5 : 𝐑
@𝟐 ↓

* Evaluate how well a multiple regression model explains the dependent variable by analyzing ANOVA table results and measures of goodness of fit

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$𝟐
𝐑 ➞ no intuitive explanation, re: %’age of variance explained
➞ no information on coefficient significance or potential
coefficient bias
➞ not a ‘goodness of fit’ measure

AIC - Akaike’s Information Criterion/ evaluates a collection of models

that explain the same DV
lower = better
adding IVs may lower
AIC = n In .𝐒𝐒𝐄D𝐧/ + 2(𝐤 + 1)
SSE, but never raise it.
lower = better penalty term

BIC - Schwartz’s Bayesian Information Criterion/

BIC = n In .𝐒𝐒𝐄D𝐧/ + InM.M134813896.
(n)(𝐤 + 1)

since In(n) > 2, BIC assesses a greater penalty

* Evaluate how well a multiple regression model explains the dependent variable by analyzing ANOVA table results and measures of goodness of fit