Correlation And Regression

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LOS a Sample Sample

covariance correlation

Measures how two variables move

together
Measures strength of linear relationship
between two variables
Captures the linear relationship between
two variables
Standardized measure of covariance
∑ (X − X) (Y − Y) Cov(x,y)
Cov(x,y) = r=
n−1 Sx × Sy
Cov(x,y) = r × Sx × Sy Unit = No unit
2
Unit = % Range = −1 to +1

Range = −∞ to +∞ r = 1 means perfectly +ve correlation

+ve covariance = Variables tend to r = 0 means no linear relationship

move together

e
r = −1 means perfectly −ve correlation
−ve covariance = Variables tend to
move in opposite directions
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−ve covariance −ve correlation −ve slope

+ve covariance +ve correlation +ve slope

Scatter plot: Graph that shows the relationship between values of two variables

LOS b Limitations to correlation analysis

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Nonlinear relationship Outliers Spurious correlation

Measures only linear Extremely large or small Appearance of causal linear

relationships, not non linear values may influence the relationship but no economic
ones estimate of correlation relationship exists

LOS c Test of the hypothesis that the population correlation coefficient equals zero
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Eg. r = 0.4 n = 62 Confidence level = 95% Perform a test of significance

Step 1: Define hypothesis H0: r = 0, Ha: r ≠ 0

r × √n − 2 0.4 × √62 − 2
Step 2: Calculate test statistic 2
3.2
√1 − r √1 − 0.42

Step 3: Calculate critical values t-distribution, DoF = 60

−2 +2
Since calculated test statistic lies outside the range, conclusion is ‘Reject the null hypothesis’
‘r’ is statistically significant, which means that population ‘r’ would be different than zero
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LOS d Dependent variable Independent variable

Variable you are seeking to Variable you are using to explain

explain changes in the dependent variable

Also referred to as explained Also referred to as explanatory

variable/endogenous variable/exogenous
variable/predicted variable variable/predicting variable

y
Rp = RFR + β (Rm − RFR)

Dependent
variable
Dependent Independent
variable variable

Intercept Slope
x
Independent
variable

LOS e Assumptions underlying linear regression

ΠRelationship between dependent and independent variable is linear

e
 Independent variable is uncorrelated with the error term
Ž Expected value of the error term is zero
 Variance of the error term is constant (NOT ZERO). The economic relationship
b/w variables is intact for the entire time period (eg. change in political regime)
 Error term is uncorrelated with other observations (eg. seasonality)
re
‘ Error term is normally distributed

Sum of squared errors (SSE): Sum of the squared vertical distances between the estimated
and actual Y-values

Regression line: Line that minimizes the SSE

Slope coefficient (beta): Describes change in ‘y’ for one unit change in ‘x’
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Cov (x,y)
Variance (x)

LOS f Standard error of estimate, coefficient of determination

and confidence interval for regression coefficient

Eg. ‘x’ 10 15 20 30

Actual ‘y’ 17 19 35 45
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Sum of squared errors

Predicted ‘y’ 15.81 23.36 30.91 46.01 (SSE)
Errors 1.19 −4.36 4.09 −1.01

Squared errors 1.416 19 16.73 1.02 38.166

SSE 38.166
Standard error of estimate (SEE) =
√ n−2
=
√ 2
= 4.36

Coefficient of determination (R2): % variation of dependent variable explained by % variation of

the independent variable
For simple linear equation, R2 = r2
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Confidence interval for regression coefficient

^
b1 ± (tc × SE)

Slope Standard
error

Critical value
(t-value)

^
Eg. b1 = 0.48 SE = 0.35 n = 42 Calculate 90% confidence interval

Confidence interval: 0.48 ± (1.684 × 0.35) −0.109 to 1.069

LOS g Hypothesis testing for population value of a regression coefficient

^
Eg. b1 = 0.48 SE = 0.35 n = 42 Confidence interval = 90% Perform a test of significance

^ ^
Step 1: Define hypothesis H0: b1 = 0, Ha: b1 ≠ 0

Sample stat. − HV 0.48 − 0

Step 2: Calculate test statistic 1.371

e
Std. error 0.35

Step 3: Calculate critical values t-distribution, DoF = 40

−1.684 1.684
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Since calculated test statistic lies inside the range, conclusion is ‘Failed to reject the null hypothesis’
Slope is not significantly different from zero

LOS h & i
Predicted value of Confidence interval for the predicted
dependent variable value of dependent variable
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^ ^ ^ ^
Y = b0 + b1 × Xp Y ± (tc × SE)

Intercept Forecasted Predicted Standard

value (x) value (y) error

Predicted Slope Critical value

value (y) (t-value)
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Eg. Forecasted return (x) = 12% Intercept = −4% Slope = 0.75 Standard error = 2.68
n = 32 Calculate predicted value (y) and 95% confidence interval

Predicted value Confidence interval

^
^ ^ ^ Y ± (tc × SE)
Y = b0 + b1 × Xp
5 ± (2.042 × 2.68)
Y = −4 + 0.75 × 12 = 5%

−0.472 to 10.472
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LOS j Analysis of variance (ANOVA)

^
Y: Mean Yi: Actual value Yi: Predicted value

Sum of squared errors Regression sum of Total sum of squares

(SSE) squares (RSS) (SST)

Measures unexplained
variation
Measures explained Measures total
variation variation
aka sum of squared
residuals ^
∑ (Yi − Yi)2 ∑ (Yi − Yi)2
^
∑ (Yi − Yi)2

ª Higher the RSS, better the quality of regression

ª R2 = RSS/SST

ª R2 = Explained variation/Total variation

ANOVA Table

e
Source of variation DoF Sum of squares Mean sum of squares

Regression
k RSS MSR = RSS/k
(explained)
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Error
n−k−1 SSE MSE = SSE/n − k − 1
(unexplained)

Total n−1 SST

F-statistic = MSR/MSE with ‘k’ and ‘n − k − 1' DoF

When to use F-test and t-test

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F-test

Y = b 0 + b 1 x1 + b 2 x2 + ε

t-test t-test

LOS k Limitations of regression analysis

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Linear relationships can change over time (parameter instability)

Public knowledge of regression relationship may make their future usefulness ineffective

If the regression assumptions are violated, hypothesis tests will not be valid
(heteroscedasticity and autocorrelation)
 Multiple Regression And Issues In
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Regression Analysis
LOS a Multiple regression equation
Y = b0 + b1 X1 + b2 X2 + …. + bk Xk + ε

Intercept Independent
variable

Dependent Slope Error

variable term

LOS b Interpreting estimated regression coefficients

Intercept Slope
term coefficient

Measures how much

dependent variable changes
Value of dependent variable

e
when independent variable
when all independent
changes by one unit,
variables are equal to zero
holding other independent
variables constant
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LOS c & d Hypothesis testing for population value of a regression coefficient

Eg. b1 = 0.15 SE1 = 0.38 b2 = 0.28 SE2 = 0.043 n = 43

Confidence interval = 90% Perform a test of significance

Step 1: Define hypothesis H0: b1 = 0, Ha: b1 ≠ 0 H0: b2 = 0, Ha: b2 ≠ 0

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Sample stat. − HV 0.15 − 0

Step 2: Calculate test statistic 0.394
Std. error 0.38

Sample stat. − HV 0.28 − 0

6.511
Std. error 0.043

Step 3: Calculate critical values t-distribution, DoF = 40

−1.684 1.684
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Since calculated test statistic (b1) lies inside the range, conclusion is ‘Failed to reject the null hypothesis’
And test statistic (b2) lies outside the range, conclusion is ‘Reject the null hypothesis’
Variable with slope ‘b1’ is not significantly different from zero
and variable with slope ‘b2’ is significantly different from zero
Solution is to drop the variable with slope ‘b1’
DoF = n − k − 1
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P-value
Reject
Reject
FTR FTR
FTR

5 ft. 3.8 ft. 4 ft. 6 ft. 4.5 ft. 5 ft.

P-value
Significance level
P-value is the lowest level of significance at which null hypothesis is rejected

LOS e
Confidence interval for Predicted value of
regression coefficient dependent variable
^ ^ ^ ^ ^ ^ ^ ^ ^
b1 ± (tc × SE) Y = b0 + b1 X1 + b2 X2 + …. + bk Xk

e
Slope Standard Intercept Forecasted
error value (x)

Critical value Predicted Slope

(t-value) value (y)
re
LOS f Assumptions of a multiple regression model

ΠRelationship between dependent and independent variable is linear

 Independent variables are uncorrelated with the error term and there is no
exact linear relation between two or more independent variables
Ž Expected value of the error term is zero
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 Variance of the error term is constant (NOT ZERO). The economic relationship
b/w variables is intact for the entire time period (eg. change in political regime)
 Error term is uncorrelated with other observations (eg. seasonality)
‘ Error term is normally distributed

LOS g F-statistic
ª F-statistic = MSR/MSE with ‘k’ and ‘n − k − 1' DoF
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ª It is used to check the quality of entire regression model

ª One-tailed test, rejection region is on right side

ª If the result of F-test is significant, at least one of the independent variable is

able to explain variation in dependent variable
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Eg. n = 48 k=6 SST = 430 SSE = 190 Significance level = 2.5% and 5%
Perform an F-test

RSS = SST − SSE 430 − 190 240

RSS 240
MSR = 40
k 6

SSE 190
MSE = 4.634
n−k−1 41

MSR 40
F-statistic = 8.631
MSE 4.634

Critical value (F-table) at 2.5% significance level (DoF 6,41) = 2.74

Calculated test statistic is on the right of critical value, therefore the conclusion is ‘Reject the null hypothesis’
Since the conclusion at 2.5% significance is ‘Reject’, the conclusion at 5% significance is also ‘Reject’
All the variables are significantly different from zero

2 2
LOS h R and adjusted R

R2: % variation of dependent variable explained by % variation of all the independent variables

e
R2 = RSS/SST

R2 = Explained variation/Total variation

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Adjusted R2 = 1− ]) n−1
n−k−1 ) ]
× (1 − R2)

Adjusted R2 < R2 in multiple regression

Eg. k=6 n = 30 R2 = 73%

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k=8 n = 30 R2 = 75%

Adjusted R21 = 1− ])30 − 1

30 − 6 − 1 )
× (1 − 0.732) ] 41.1%

Adjusted R22 = 1− ])30 − 1

30 − 8 − 1 )
× (1 − 0.752) ] 39.58%

Adding two more variables is not justified because adjusted R22 < adjusted R21
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LOS i ANOVA table

Source of variation DoF Sum of squares Mean sum of squares

Regression
k RSS MSR = RSS/k
(explained)
Error
n−k−1 SSE MSE = SSE/n − k − 1
(unexplained)

Total n−1 SST

F-statistic = MSR/MSE with ‘k’ and ‘n − k − 1' DoF

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LOS j Multiple regression equation by using dummy variables

Y = b0 + b1 X1 + b2 X2 + …. + bk Xk + ε

Intercept Independent
variable

Dependent Slope Error

variable term

Dummy variables: Independent variables that are binary in nature (i.e. in the form of yes/no)

They are qualitative variables

Values: If true = 1, if false = 0

Use n – 1 dummy variables in the model

LOS k & l Types of heteroskedasticity

Conditional Unconditional

e
Occurs when Occurs when
heteroskedasticity of heteroskedasticity of
the error variance is the error variance is
correlated with the not correlated with the
re
independent variables independent variables

Causes problems for Does not cause major

statistical inference problems for statistical
inference
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Conditional Positive serial Negative serial

Violations Multicollinearity
heteroskedasticity correlation correlation

Two or more
Variance not Errors are Errors are
Meaning independent variables
constatnt correlated correlated
are correlated

Effect Type I errors Type I errors Type II errors Type II errors

Examining scatter
Durbin-Watson Durbin-Watson F - significant
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Detection plots or Breusch-

test test t - not significant
Pagan test

White-corrected Drop one of the

Correction Hansen method Hansen method
standard errors variables

ª Breusch-Pagan test: n × R2
ª White-corrected standard errors is also known as robust standard error
ª Durbin-Watson test ≈ 2(1 − r).
ª Multicollinearity: The question is never a yes or no, it is how much
ª None of the assumption violations have any impact on slope coefficients.
The impact is on standard errors and therefore on t-test
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LOS m

Model Model
specifications misspecifications

Model should have strong

Omitting a variable
economic reasoning
Variable should be transformed
Functional form of the variables
should be appropriate
Incorrectly pooling data
The model should be
Using lagged dependent variable
parsimonious (concise/brief)
as an independent variable
The model should be examined
Forecasting the past
for violations of assumptions
Measuring independent variables
Model should be tested on out of
with error
sample data

Model misspecifications might have impact on both slope coefficient and error terms

e
LOS n Models with qualitative dependent variables

Probit Logit Discriminant

re
Similar to probit and logit
Based on the normal Based on the logistic
but uses financial ratios as
distribution distribution
independent variables
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LOS o Interpretation of multiple regression model

Values of slope coefficients suggest that there is economic relationship

between the independent and dependent variables

But it may also be possible for a regression to have statistical

significance even when there is no economic relationship

This statistical significance must also be factored into the analysis

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 Time-series Analysis
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LOS a Predicted trend value for a time series

Time series: Set of observations on a variable’s outcomes in different time periods

Used to explain the past and make predictions about the future

Linear trend Log-linear

models trend models

Log-linear trend is a trend in

Linear trend is a trend in which the dependent variable
which the dependent variable changes at an exponential
changes at a constant rate rate with time
with time
Used for financial time series
Has a straight line
Has a curve
Upward-sloping line:
+ve trend Convex curve:
+ve trend

e
Downward-sloping line:
−ve trend Concave curve:
−ve trend
Equation:
yt = b0 + b1t + εt Equation:
re
ln yt = b0 + b1t + εt

LOS b How to determine which model to use

Plot the data

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y y

x x
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Linear trend Log-linear

model trend model

Limitation of trend models is that they are not useful if the error terms are serially correlated
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LOS c Requirement for a time series to be covariance stationary

A time series is covariance stationary if it satisfies the following three conditions:

Constant and finite mean

Constant and finite variance (same as homoskedasticity)

Constant and finite covariance of time series with itself

Eg. Xt = b0 + b1 Xt−1

Xt = 5 + 0.5 Xt−1

Xt − 1 = 6 Xt = 8 Xt − 1 = 20 Xt = 15

Xt − 1 = 8 Xt = 9 Xt − 1 = 15 Xt = 12.5

e
Xt − 1 = 9 Xt = 9.5 Xt − 1 = 12.5 Xt = 11.25
re
Xt − 1 = 10 Xt = 10

If Xt − 1 = 10, then Xt = 10, Xt + 1 = 10, Xt + 2 = 10 and so on

This is called constant and finite mean

b0 5
Mean of the time series = = = 10
1 − b1 1 − 0.5
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For a model to be valid, time series must be covariance stationary

Most economic and financial time series relationships are not stationary

The model can be used if the degree of nonstationarity is not significant

LOS d Autoregressive (AR) model

Fi

AR model: A time series regressed on its own past values

Equation AR(1): Xt = b0 + b1Xt − 1 + εt

Equation AR(2): Xt = b0 + b1Xt − 1 + b2Xt − 2 + εt

Chain rule of forecasting: Calculating successive forecasts

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LOS e Autocorrelations of the error terms

If the error terms have significant serial correlation (autocorrelation), the AR

model used is not the best model to analyze the time series

Procedure to test if the AR model is correct:

Step 1: Calculate the intercept and slope using linear regression

Step 2: Calculate the predicted values
Step 3: Calculate the error terms
Step 4: Calculate the autocorrelations of the error terms
Step 5: Test whether the autocorrelations are significantly different from zero

If the autocrrelations are not statistically If the autocrrelations are statistically

significant from zero (if the decision is FTR): significant from zero (if the decision is reject):
Model fits the time series Model does not fit the time series

Test used to know if the autocorrelations are significantly different from zero: t-test

Autocorrelation
t statistic =
Standard error

LOS f Mean reversion

e
It means tendency of time series to move toward its mean
b0
Mean reverting level =
1 − b1
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LOS g In-sample and out-of-sample forecasts and RMSE criterion

Sample Predicted Squared

Eg. Xt − 1 Error
value (Xt) value errors

200 - - - -

220 200 216.5 3.5 12.25

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215 220 227.8 −12.8 163.84

205 215 225 −20 400

235 205 219.4 15.6 243.36

250 235 236.4 13.6 184.96

1004.41
Fi

In-sample root mean SSE 1004.41

squared error (RMSE) √ n √ 5
= 14.17
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Eg. Actual Predicted Squared

Error
value value errors

215 - - -

235 225 10 100

220 236.4 −16.4 268.96

240 227.9 12.1 146.41

250 239.2 10.8 116.64

632

Out-of-sample root mean SSE 632

squared error (RMSE) √ n √ 4
= 12.57

Select the time series with lowest out-of-sample RMSE

LOS h Instability of coefficients of time-series models

One of the important issues in time series is the sample period to use

e
Shorter sample period → More stability but less statistical reliability
Longer sample period → Less stability but more statistical reliability

Data must also be covariance stationary for model to be valid

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LOS i Random walk
Random walk
with a drift

A time series in which

A time series in which predicted value of a dependent
predicted value of a dependent variable in one period is equal
variable in one period is equal to the value of dependent
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to the value of dependent variable in previous period

variable in previous period plus or minus a constant
plus an error term amount and an error term

Equation: Equation:
Xt = Xt − 1 + εt Xt = b0 + Xt − 1 + εt

ª Both of the above equations have a slope (b1) of 1

Fi

ª Such time series are said to have ‘unit root’

ª They are not covariance stationary because they do not have a finite mean

ª To use standard regression analysis, we must convert this data to covariance stationary.
This conversion is called ‘first differencing’
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LOS j & k Unit root test of nonstationarity

Autocorrelation Dickey-Fuller
approach test

If autocorrelations do not exhibit More definitive than

these characteristics, it is said to autocorrelation approach
be a nonstationary time series:
Xt − Xt − 1 = b0 + b1Xt − 1 − Xt − 1 + εt
Autocorrelations at all lags are
statistically insignificant from zero
Xt − Xt − 1 = b0 + (b1 − 1)Xt − 1 + εt
or
If null (b1 − 1 (g) = 0) can not be
As the no. of lags increase, the rejected, the time series has a unit
autocorrelations drop down to zero root

First differencing
Eg. Sales Lag 1 First difference

- -
∆ sales

e ∆ sales
(current year) (previous year)
re
230 - - -

270 230 40 -

290 270 20 40

310 290 20 20
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340 310 30 20

^ ^ ^
Equation: y = 30 − 0.25x Equation: y = 30 − 0.25(340) y = (55)
Forecasted sales: 340 − 55 = 285
If time series is a random walk then we must convert this data to covariance stationary.
This conversion is called first differencing

LOS l How to test and correct for seasonality

Fi

Seasonality can be detected by plotting the values on a graph or calculating autocorrelations

Seasonality is present if the autocorrelation of error term is significantly different from zero

Correction: Adding a lag of dependent variable (corresponding to the same period in previous year)
to the model as another independent variable
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LOS m Autoregressive conditional heteroskedasticity (ARCH)

ARCH exists if the variance of error terms in one period is
dependent on the variance of error terms in previous period

Testing: Squared errors from the model are regressed on the first
lag of the squared residuals

^2 ^2
Equation: εt = a0 + a1 εt − 1 + μt

Intercept Predicted
error term of
last period

Predicted Slope Error

error term of term
current period

LOS n How time-series variables should be analyzed for

nonstationarity and/or cointegration

To test whether the two time series have unit roots, a Dickey-Fuller test is used

e
Possible scenarios:

ΠBoth time series are covariance stationary (linear regression can be used)
 Only the dependent variable time series is covariance stationary (linear regression
re
should not be used)
Ž Only the independent variable time series is covariance stationary (linear regression
should not be used)
 Neither time series is covariance stationary and the two series are not cointegrated
(linear regression should not be used)
 Neither time series is covariance stationary and the two series are cointegrated
(linear regression can be used)
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Cointegration: Long term economic or financial relationship between two time series

LOS o Appropriate time-series model to analyze a given investment problem

ª Understand the investment problem you have and make a choice of model

ª If you have decided to use a time-series model plot the values to see whether the time series
looks covariance stationary
Fi

ª Use a trend model, if there is no seasonality or structural shift

ª If you find significant serial correlation in the error terms, use a complex model such as AR model

ª If the data has serial correlation, reexamine the data for stationarity before running an AR model

ª If you find significant serial correlation in the residuals, use an AR(2) model

ª Check for seasonality

ª Test whether error terms have ARCH

ª Perform tests of model's out-of-sample forecasting performance (RMSE)

 Probabilistic Approaches: Scenario Analysis,
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Decision Trees And Simulations

LOS a, b & c Steps in running a simulation

Step 1 Determine probabilistic variables: No constraint on number of input variables that can be
allowed to vary.
Focus on a few variables that have significant impact on
value.

Step 2 Define probability distributions Three ways to define probability distribution

for these variables:
Historical data: Useful when past data is available and
reliable. Estimate the distribution based on past values.
Cross-sectional data: Useful when past data is
unavailable or unreliable. Estimate the distribution
based on the values of similar variables.
Statistical distribution and parameters: Useful when
historical and cross sectional data is insufficient or
unreliable. Estimate the distribution and its parameters.

e
Step 3 Check for correlation across If the correlation is strong, either allow only one of the
variables: variables to vary (focus on the variable that has the
highest impact on value) or build the correlation into
re
the simulation

Step 4 Run the simulation: It means to draw an outcome from each distribution
and compute the value based on these outcomes
Number of probabilistic inputs: Higher the number of
probabilistic inputs, greater the number of simulations
required.
Types of distributions: Greater the diversity of
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distributions, greater the number of simulations

required.
Range of outcomes: Greater the range of outcomes,
greater the number of simulations required.

LOS d Advantages of using simulations in decision making

Fi

Provides a distribution of expected

Better input estimation
value rather than a point estimate

An analyst will usually examine both

historical and cross-sectional data
Simulations provide distribution of
to select a proper distribution and
expected value however they do not
its parameters, instead of relying on
provide better estimates
single best estimates. This results in
better quality of inputs

Simulations do not always lead to better decisions

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LOS e Common constraints introduced into simulations

Book value constraints Earnings and CF constraints Market value constraints

Imposed internally:
Regulatory capital Likelihood of financial
Analyst’s expectations
restrictions distress
Imposed externally:
Negative equity Indirect bankruptcy costs
Loan covenants

LOS f Issues in using simulations in risk assessment

ª Garbage in, garbage out: Inputs should be based on analysis and data, rather than guesswork

ª Inappropriate probability distributions: Using probability distributions that have no

resemblance to the true distribution of an input variable will provide misleading results

ª Non-stationary distributions: Distributions may change over time due to change in market

e
structure. There can be a change the form of distribution or the parameters of the distribution

ª Dynamic correlations: Correlation across input variables can be modeled into simulations only
when they are stable. If they are not it becomes far more difficult to model them
re
Risk-adjusted value
Cash flows from simulations are not risk-adjusted and should not be discounted at RFR

Eg. Risk-adjusted Expected value σ from

Asset
discount rate using simulation simulation

A 15% $100 17%

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B 18% $100 21%

ª We have already accounted for B’s greater risk by using a higher discount rate

ª If we choose A over B on the basis of A’s lower standard deviation, we would

be penalizing Asset B twice

ª An investor should be indifferent between the two investments

Fi

LOS g Selecting appropriate probabilistic approach

Type of risk Correlated? Sequential? Appropriate approach

Continuous Yes Doesn’t matter Simulation

Discrete Yes No Scenario analysis

Discrete No Yes Decision tree