Discuss, with reference to an empirical study, the applicability of APT for estimating excess stock returns. Please note that there are no limitations on the year of the year.

FN585: Financial Modelling and Dealing

Task: to estimate the excess returns on a stock of your choice applying the Arbitrage Pricing Theory (APT).

Aim: to evaluate your understanding of financial theory to transform data into correct form, to model financial relationships and correctly interpret the findings. The analysis of the results is the most important stage of the assignment. It involves estimating an initial model or models, performing appropriate diagnostic tests, re-forming and re-estimating, and conducting tests of hypothesis.
Format: The assignment consists of three parts comprising a written report of a maximum of 1,500 words. A pdf format of the report, including the EViews output in an Appendix, to be uploaded via My Studies.

Presentation instructions:

1. Do not just cut and paste EViews output into your coursework, create your own tables to fit your needs. However, all estimation results (from EViews) must be collected in an Appendix and clearly referenced in the text (i.e., referring to a table or a graph number in the Appendix). 2. You should consider including a comparative table of results (in terms of different variables). 3. PLEASE tabulate your results in the main draft, simply cutting and pasting EViews output is not acceptable. 4. No marks will be awarded for output results without explanations. 5. Appropriate notation: numbers should be reported with up to 3 decimal points; use Word equation editor if typing formulas; use uniform reference formatting (e.g., Chicago); use at least font size 11. 6. Do all hypothesis tests properly. For instance, the way you report the significance of a coefficient reveals how well you understand hypothesis testing.
Specific instructions on performing the task:

PART 1: (25 marks)

1. Carefully explain the APT, outlining the mathematical model, underpinning it, appropriately referenced. [8 marks]

2. Discuss, with reference to an empirical study, the applicability of APT for estimating excess stock returns. Please note that there are no limitations on the year of the
FN585: Financial Modelling and Dealing
2
publication. It can be a more recent study or a seminal work, but not the example discussed in class. [8 marks]
3. Briefly, provide a background information on your chosen company. [2 marks]
4. Present and explain the model you will be estimating based on the APT, in the context of your data. Your model should be of the form:
Yt =  + β1X1t + β2X2t + ut ut ~ N (0, σ2) [7 marks]

PART 2: (30 marks)

1. Collect monthly data, for a five-year period, with reference to the relevant sources, on:
a) the prices for your chosen stock
b) the corresponding market index prices
c) the relevant risk-free asset returns
d) a macroeconomic indicator of your choice
Relevant data is available from: Yahoo Finance, FRED (The Federal Reserve Bank of St. Louis),

Kenneth R. French Data Library, IMF, and the World Bank. [6 marks]
2. Compile an Excel worksheet and import the data into EViews. [1 mark]
3. Make the necessary data transformations. [10 marks]
4. Test the variables for unit-root; carefully formulate the hypothesis and make a correction, if possible. [6 marks]
5. Investigate the variables included in your model. Present in a table and briefly interpret
the respective summary statistics. Include two scatter plots of relevant variables. [7 marks]

PART 3: (35 marks)

1. Estimate the model and test if it conforms to three of the classical OLS assumptions for the residuals: homoscedasticity; no series correlation and normality. You are required to make any corrections that are possible. [10 marks]
2. Carefully specify the hypotheses for testing the assumptions on the residuals, the individual coefficients and the F-test for overall significance. [8 marks]
FN585: Financial Modelling and Dealing

3
3. Correctly interpret the estimated coefficients in terms of their signs, significance and impact on the dependent variable. [6 marks]
4. Correctly interpret the R2 and the F-statistic. [6 marks]
5. Briefly compare your findings with the article surveyed in Part 1. [5 marks]
Structure: The three parts, with the detailed instructions, should provide the structure of your report. [2 marks]

Presentation: as per presentation instructions on p.1 of this brief [5 marks]
Referencing: Use uniform reference formatting (e.g., Chicago or Harvard) – please see the Brighton Business School Referencing Handbook for detailed guidance. [3 marks]
References
Data Websites

World Bank: http://data.worldbank.org/
IMF: http://www.imf.org/external/data.htm (IMF)
Yahoo Finance: https://finance.yahoo.com/
Federal Reserve Economic Data (FRED): http://research.stlouisfed.org/fred2/
Kenneth R. French Data Library: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html#Research

Texts

Asteriou, D. and Hall, S. Applied Econometrics. Palgrave. Available online through the Aspire Reading List of the module at: http://web.b.ebscohost.com.ezproxy.brighton.ac.uk/ehost/detail/detail?vid=0&sid=5 c7c445a-dd26-46c8-9b0d-9e0b1760153c%40pdc-v- sessmgr05&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#AN=1526022&db=nl ebk
Barrow, M. Statistics for Economics, Accounting and Business Studies, Pearson. Available online through the Aspire Reading list of the module at: https://www.vlebooks.com/Vleweb/Product/Index/915704?page=0
Brooks, C. Introductory Econometrics for Finance, Cambridge University Press.

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