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Financial Econometrics

A. How are the factors computed and what do they represent? (Hint: Look at the Fama
and French 1993 paper – its on iLearn). Briefly describe major company characteristics
of CVS Health. (2 marks)
B. Create log returns (in percent, e.g. 3.25%) and name them r _ cvs. Calculate the excess
return on cvs stock as r _ cvs  rf and name it er _ cvs. Consider the following
0 1 2 3 _ _ t t t t t er cvs    mkt rf  hml  smb 
What signs (positive or negative) would you expect to estimate for each of the factors?
Why? (3 marks)
C. Estimate the model in B and present the fitted equation. Interpret the fitted
coefficients. Which parameters are statistically significant at the 5% level? Are the
estimated parameters of the same sign as you expected in B? (4 marks)
D. Conduct a test for the validity of the CAPM. What do you find? (3 marks)
E. Conduct the basic diagnostic tests on the estimated model, i.e. autocorrelation (use 4
lags of residuals), heteroskedasticity (no cross product), non‐normality,
misspecification of functional form (only quadratic term). Comment on your results
and suggest remedies to any problems you may detect. (You are NOT required to
carry out the remedy to any problem you may detect. If you see a problem, state what
it is and simply describe what could be done). (3 marks)
Part 2
Part 2 ‐ Total number of marks: 15
The Eviews workfile “Part2_Assignment_Workfile.wf1” located under “Assignment” heading
on iLearn contains daily adjusted closing price for Qantas from 01 Jan 2007 to 12 April 2016,
which is 2,414 daily observations. It is designated “Qan” in the workfile.
A. Plot a graph of the Qantas share price, and comment on its salient features. Conduct
an ADF unit‐root test on the price series. Be careful to properly state the null and
alternative hypothesis for the test. Comment on your findings.
(2 marks)
B. Generate a new variable for the daily log returns (in percentage terms) for Qantas.
Name this variable r _ qan. Present a graph of the return series along with summary
statistics, and comment. Conduct a KPSS unit‐root test on the returns for Qantas. Be
careful to properly state the null and alternative hypothesis for the test. Comment on
your findings.
(2 marks)
C. Plot the ACF and PACF functions for Qantas returns (include 5 lags). On the basis of
these results, you decide to estimate three models for Qantas returns. They are:
1 _ t t r qan    (1)
1 2 1 _ t t t r qan         (2)
1 2 1 _ _ t t t r qan   r qan      (3)
Which model do you think is the best from among these three?
(2 marks)
D. Re‐estimate the model you selected in Part C by adding, respectively, an i) ARCH(5),
ii) GARCH(1,1) and iii) GJR(1,1,1) specification. What are these models, and how do
they differ? Report the fitted equations, comment on the output, including a careful
interpretation of the parameters in the volatility equation, and compare across the
three specifications. Provide graphs of the estimated conditional variances and
comment on them. Overall, which one of the three specifications do you prefer?
(9 marks)

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