Lecture 3

A brief overview of the

classical linear regression model

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Learning Objectives
• Introduction to regression analysis
• Relationship between regression and correlation
• Difference between a deterministic relationship and a statistical
relationship – importance of the error term
• Ordinary Least Square estimator (OLS)
• Population regression function and sample regression function
• Assumption of the Classical Linear Regression model
• Properties of the OLS estimator
• Test hypotheses using the test of significance and confidence
interval approaches

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Regression

• Regression is probably the single most important tool at the

econometrician’s disposal.

But what is regression analysis?

• It is concerned with describing and evaluating the relationship between

a given variable (usually called the dependent variable) and one or more
other variables (usually known as the independent variable(s)).

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 Some Notation

• Denote the dependent variable by y and the independent variable(s) by x1,

x2, ... , xk where there are k independent variables.

• Some alternative names for the y and x variables:

y x
dependent variable independent variables
regressand regressors
effect variable causal variables
explained variable explanatory variable

• Note that there can be many x variables but we will limit ourselves to the case
where there is only one x variable to start with. In our set-up, there is only one
y variable.

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 Regression is different from Correlation

• If we say y and x are correlated, it means that we are treating y and x in a

completely symmetrical way.

• In regression, we treat the dependent variable (y) and the independent

variable(s) (x’s) very differently. The y variable is assumed to be random or
“stochastic” in some way, i.e. to have a probability distribution. The x
variables are, however, assumed to have fixed (“non-stochastic”) values in
repeated samples.

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 Simple Regression

• For simplicity, say k=1. This is the situation where y depends on only one x
variable.

• Examples of the kind of relationship that may be of interest include:

• How asset returns vary with their level of market risk

• Measuring the long-term relationship between stock prices and
dividends.
• Constructing an optimal hedge ratio

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Simple Regression: An Example

• Suppose that we have the following data on the excess returns on a fund
manager’s portfolio (“fund XXX”) together with the excess returns on a market
index:

Year, t Excess return Excess return on market index

= rXXX,t – rft = rmt - rft
1 17.8 13.7
2 39.0 23.2
3 12.8 6.9
4 24.2 16.8
5 17.2 12.3
• We have some intuition that the beta on this fund is positive, and we therefore
want to find whether there appears to be a relationship between x and y given
the data that we have. The first stage would be to form a scatter plot of the two
variables.

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 Graph (Scatter Diagram)

45
40
Excess return on fund XXX

35
30
25
20
15
10
5
0
0 5 10 15 20 25
Excess return on market portfolio
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 Finding a Line of Best Fit

• We can use the general equation for a straight line,

y = a + bx
to get the line that best “fits” the data.

• However, this equation (y = a + bx) is completely deterministic.

• Is this realistic? No. So what we do is to add a random disturbance term, u

into the equation.
y t =  +  xt + u t
where t = 1,2,3,4,5

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Why do we include a Disturbance term?

• The disturbance term can capture a number of features:

- We always leave out some determinants (Elements/Factors) of yt

- There may be errors in the measurement of yt that cannot be modelled.

- Random outside influences on yt which we cannot model

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 Determining the Regression Coefficients

• So how do we determine what  and  are?

• Choose  and  so that the (vertical) distances from the data points to the
fitted lines are minimised (so that the line fits the data as closely as
possible):
y

x
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Ordinary Least Squares

• The most common method used to fit a line to the data is known as OLS
(ordinary least squares).

• What we actually do is take each distance and square it (i.e. take the
area of each of the squares in the diagram) and minimise the total sum
of the squares (hence least squares).

• Tightening up the notation, let

yt denote the actual data point t
ŷt denote the fitted value from the regression line
ût denote the residual, yŷt t-

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Actual and Fitted Value
y

yi

û i

ŷ i

xi x

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How OLS Works
5

uˆ12  uˆ 22  uˆ32  uˆ 42  uˆ52  uˆ

t 1
2
t

ût
ŷt


 t t
y  ˆ
y 2
 t
ˆ
u 2

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 yˆ t  1.74  1.64 x t

yˆ i  1.74  1.64 20  31.06

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Accuracy of Intercept Estimate

• Care needs to be exercised when considering the intercept estimate,

particularly if there are no or few observations close to the y-axis:
y

0 x
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 The Population and the Sample

• The population is the total collection of all objects or people to be studied,

for example,

• Interested in Population of interest

predicting outcome the entire electorate
of an election

• A sample is a selection of just some items from the population.

• A random sample is a sample in which each individual item in the

population is equally likely to be drawn.

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The DGP, the PRF and the SRF

• The population regression function (PRF) is a description of the model

that is thought to be generating the actual data and the true relationship
between the variables (i.e. the true values of  and ).

• The PRF is yt    xt  ut

• The SRF is yˆ t  ˆ  ˆxt

and we also know that uˆt  yt  yˆ.t

• We use the SRF to infer likely values of the PRF.

• We also want to know how “good” our estimates of  and  are.

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 Estimator or Estimate?

• Estimators are the formulae used to calculate the coefficients

• Estimates are the actual numerical values for the coefficients.

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The Assumptions Underlying the
Classical Linear Regression Model (CLRM)

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Properties of the OLS Estimator

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An Introduction to Statistical Inference

yˆ t  20.3  0.5091xt
(14.38) (0.2561)

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Hypothesis Testing: Some Concepts

• We can use the information in the sample to make inferences about the
population.
• We will always have two hypotheses that go together, the null hypothesis
(denoted H0) and the alternative hypothesis (denoted H1).
• The null hypothesis is the statement or the statistical hypothesis that is actually
being tested. The alternative hypothesis represents the remaining outcomes of
interest.
• For example, suppose given the regression results above, we are interested in the
hypothesis that the true value of  is in fact 0.5. We would use the notation
H0 :  = 0.5
H1 :   0.5
This would be known as a two sided test.

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One-Sided Hypothesis Tests

• Sometimes we may have some prior information that, for example, we would
expect  > 0.5 rather than  < 0.5. In this case, we would do a one-sided test:

H0 :  = 0.5
H1 :  > 0.5
or we could have had
H0 :  = 0.5
H1 :  < 0.5

• There are two ways to conduct a hypothesis test: via the test of significance
approach or via the confidence interval approach.

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The Probability Distribution of the
Least Squares Estimators

• We assume that ut  N(0,2)

• What if the errors are not normally distributed? Will the parameter estimates still
be normally distributed?

• Yes, if the other assumptions of the CLRM hold, and the sample size is
sufficiently large.

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Testing Hypotheses:

The Test of Significance Approach

yt    xt  ut

*
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The Test of Significance Approach (cont’d)

3. We need some tabulated distribution with which to compare the estimated test statistics. Test
statistics derived in this way can be shown to follow a t-distribution with T-2 degrees of freedom.

More degree of freedom means more observations available to estimate the unknown population parameters and
calculate the variable of these estimates. In estimations, n-1 means you have n-1 observations available to estimate
the parameter for example sample standard deviation. In simple Linear Regression T-2, means you have T-2
observations available to estimate two unknown population parameters.

As the number of degrees of freedom increases, we need to be less cautious in our approach since we
can be more sure that our results are robust.

4. We need to choose a “significance level”, often denoted . This is also sometimes called the size of
the test and it determines the region where we will reject or not reject the null hypothesis that we are
testing. It is conventional to use a significance level of 5%.
Intuitive explanation is that we would only expect a result as extreme as this or more extreme 5% of the
time as a consequence of chance alone.
Conventional to use a 5% size of test, but 10% and 1% are also commonly used.

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Determining the Rejection Region for a Test of
Significance
5. Given a significance level, we can determine a rejection region and non
rejection region. For a 2-sided test:

f(x)

2.5% 95% non-rejection 2.5%

rejection region region rejection region

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The Rejection Region for a 1-Sided Test
(Upper Tail) B>B*

f(x)

95% non-rejection
region 5% rejection region

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The Rejection Region for a 1-Sided Test
(Lower Tail) B<B*

f(x)

95% non-rejection region

5% rejection region

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The Test of Significance Approach: Drawing Conclusions

6. Use the t-tables to obtain a critical value or values with which to compare
the test statistic.

7. Finally perform the test. If the test statistic lies in the rejection region then
reject the null hypothesis (H0), else do not reject H0.

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The Confidence Interval Approach
to Hypothesis Testing

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How to Carry out a Hypothesis Test
Using Confidence Intervals

( ˆ  t crit  SE ( ˆ ), ˆ  t crit  SE ( ˆ ))

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Confidence Intervals Versus Tests of Significance
• Note that the Test of Significance and Confidence Interval approaches always give the same
answer.

• Under the test of significance approach, we would not reject H 0 that  = * if the test statistic lies
within the non-rejection region, i.e. if

   *
t crit    tcrit
SE (  )
• Rearranging, we would not reject if

 t crit  SE ( ˆ )  ˆ   *  t crit  SE ( ˆ )

• But this is just the rule under the confidence interval approach.
ˆ  t crit  SE ( ˆ )   *  ˆ  t crit  SE ( ˆ )

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Constructing Tests of Significance and
Confidence Intervals: An Example

• Using the regression results above,

yˆ t  20.3  0.5091xt
, T = 22
(14.38) (0.2561)

• Using both the test of significance and confidence interval approaches, test
the hypothesis that  =1 against a two-sided alternative.

• The first step is to obtain the critical value. We want tcrit = t20;5%

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Determining the Rejection Region

f(x)

2.5% rejection region 2.5% rejection region

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Performing the Test

• The hypotheses are:

H0 :  = 1
H1 :   1

Test of significance Confidence interval

approach approach

   * ˆ  t crit  SE ( ˆ )
test stat 
SE (  )
05091
. 1  0.5091  2.086  0.2561
  1917
.
0.2561  (0.0251,1.0433)
Do not reject H0 since
Since 1 lies within the
test stat lies within confidence interval,
non-rejection region do not reject H0

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Testing other Hypotheses

• What if we wanted to test H0 :  = 0 or H0 :  = 2?

• Note that we can test these with the confidence interval approach.
For interest (!), test
H0 :  = 0
vs. H1 :   0

H0 :  = 2
vs. H1 :   2

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Changing the Size of the Test

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Changing the Size of the Test:
The New Rejection Regions

f(x)

5% rejection region 5% rejection region

-1.725 +1.725

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Changing the Size of the Test:
The Conclusion

• t20;10% = 1.725. So now, as the test statistic lies in the rejection region, we
would reject H0.

• Caution should therefore be used when placing emphasis on or making

decisions in marginal cases (i.e. in cases where we only just reject or not
reject).

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 Some More Terminology

• If we reject the null hypothesis at the 5% level, we say that the result of the
test is statistically significant.

• Note that a statistically significant result may be of no practical significance.

E.g. if a shipment of cans of beans is expected to weigh 450g per tin, but
the actual mean weight of some tins is 449g, the result may be highly
statistically significant but presumably nobody would care about 1g of
beans.

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The Errors That We Can Make
Using Hypothesis Tests
• We usually reject H0 if the test statistic is statistically significant at a chosen
significance level.

• There are two possible errors we could make:

1. Rejecting H0 when it was really true. This is called a type I error.
2. Not rejecting H0 when it was in fact false. This is called a type II error.
Reality
H0 is true H0 is false
Significant Type I error 
Result of (reject H0) =
Test Insignificant Type II error
( do not  =
reject H0)
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 The Trade-off Between Type I and Type II Errors

• The probability of a type I error is just , the significance level or size of test we chose.
To see this, recall what we said significance at the 5% level meant: it is only 5% likely
that a result as or more extreme as this could have occurred purely by chance.
• Note that there is no chance for a free lunch here! What happens if we reduce the size
of the test (e.g. from a 5% test to a 1% test)? We reduce the chances of making a type
I error ... but we also reduce the probability that we will reject the null hypothesis at
all, so we increase the probability of a type II error:
less likely
to falsely reject
Reduce size  more strict  reject null
of test criterion for hypothesis more likely to
rejection less often incorrectly not
reject
• So there is always a trade-off between type I and type II errors when choosing a
significance level. The only way we can reduce the chances of both is to increase the
sample size.

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A Special Type of Hypothesis Test: The t-ratio

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 The t-ratio: An Example

• Suppose that we have the following parameter estimates, standard errors and
t-ratios for an intercept and slope respectively.
Coefficient 1.10 -4.40
SE 1.35 0.96
t-ratio 0.81 -4.63

Compare this with a tcrit with 15 - 3 = 12 d.f.

(2½% in each tail for a 5% test) = 2.179 5%
= 3.055 1%
• Do we reject H0: 1 = 0? (No)
H0: 2 = 0? (Yes)

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 What Does the t-ratio tell us?

• If we reject H0, we say that the result is significant. If the coefficient is not
“significant” (e.g. the intercept coefficient in the last regression above), then it
means that the variable is not helping to explain variations in y. Variables
that are not significant are usually removed from the regression model.
• In practice there are good statistical reasons for always having a constant
yt
even if it is not significant. Look at what happens if no intercept is included:

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An Example of the Use of a Simple t-test to Test a
Theory in Finance
• Testing for the presence and significance of abnormal returns (“Jensen’s alpha” -
Jensen, 1968).

• The Data: Annual Returns on the portfolios of 115 mutual funds from 1945-1964.

• The model: R jt  R ft   j   j ( Rmt  R ft )  u jt for j = 1, …, 115

• We are interested in the significance of j.

• The null hypothesis is H0: j = 0 .

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Frequency Distribution of t-ratios of Mutual Fund
Alphas (gross of transactions costs)

Source Jensen (1968). Reprinted with the permission of Blackwell publishers.

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Frequency Distribution of t-ratios of Mutual Fund
Alphas (net of transactions costs)

Source Jensen (1968). Reprinted with the permission of Blackwell publishers.

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Can UK Unit Trust Managers “Beat the
Market”?

• We now perform a variant on Jensen’s test in the context of the UK market,

considering monthly returns on 76 equity unit trusts. The data cover the
period January 1979 – May 2000 (257 observations for each fund). Some
summary statistics for the funds are:
Mean Minimum Maximum Median
Average monthly return, 1979-2000 1.0% 0.6% 1.4% 1.0%
Standard deviation of returns over time 5.1% 4.3% 6.9% 5.0%

• Jensen Regression Results for UK Unit Trust Returns, January 1979-May

2000
R jt  R ft   j   j ( Rmt  R ft )   jt

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 Can UK Unit Trust Managers “Beat the Market”?
: Results

Estimates ofMean Minimum Maximum Median

 -0.02 -0.54% 0.33% -0.03%
 0.91 0.56 1.09 0.91
t-ratio on  -0.07 -2.44 3.11 -0.25

• In fact, gross of transactions costs, 9 funds of the sample of 76 were able to

significantly out-perform the market by providing a significant positive alpha,
while 7 funds yielded significant negative alphas.

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The Overreaction Hypothesis and
the UK Stock Market
• Motivation
Two studies by DeBondt and Thaler (1985, 1987) showed that stocks which
experience a poor performance over a 3 to 5 year period tend to outperform
stocks which had previously performed relatively well.
• How Can This be Explained?
2 suggestions
1. A manifestation of the size effect
DeBondt & Thaler did not believe this a sufficient explanation, but Zarowin
(1990) found that allowing for firm size did reduce the subsequent return on the
losers.
2. Reversals reflect changes in equilibrium required returns
Ball & Kothari (1989) find the CAPM beta of losers to be considerably higher
than that of winners.

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The Overreaction Hypothesis and
the UK Stock Market (cont’d)

• Another interesting anomaly: the January effect.

• Another possible reason for the superior subsequent performance of losers.
• Zarowin (1990) finds that 80% of the extra return available from holding the losers
accrues to investors in January.

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References
• Brooks, C. (2013). Introductory Econometrics for Finance, 3rd Ed,
Cambridge University Press

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