Financial Econometrics Assignment 2
Financial Econometrics Assignment 2
Financial Econometrics Assignment 2
b) When β < 0
When β < 0, there is a negative
relationship between the
dependent and independent
variables and this is depicted by a
downward sloping straight line
Analysis: To study the research problem of whether capital structure affects a firm’s
performance, we consider the following econometric model:
This is an example of the Linear – in – Variables Model, as the dependent variable (ROCE)
and independent variable (Capital Structure) are linearly related.
Interpretation of slope coefficient: As per the OLS regression results, the value of β1 =
-12.98158 which indicates that due to a unit change in D/E, the absolute value of ROCE will fall
by 12.98158.
This is the structural form of a Log – Log model. By taking log on both sides, the non – linear
relationship between the variables is transformed into a linear one. After the log
transformation, the model is linear in the parameters and also linear in the log of variables
and thus is called a Double – log or log – linear model.
ln Yi = α + β1.(ln Xi) + µi
On differentiating both sides, we observe that
Rate of change in ln Y = β1.(Rate of change in ln X)
δY/Y = β1.(δX/X)
Elasticity = (δY/Y)/ (δX/X) = β1
This implies that the elasticity in a log transformation model is constant throughout the
model and its value is equal to β1. Thus, this model is also termed as a Constant Elasticity
Model.
It can be inferred that the coefficients in a log-log model represent the elasticity of Y
variable with respect to the X variable. In other words, the coefficient is the estimated
percent change in your dependent variable for a percent change in your independent
variable.
The value of the coefficient β1 is 0.3249. This implies that a 1% change in the Ln Maruti
causes a 32.49% change in the Ln Nifty. Since β1 is positive, it indicates that there is a
positive relationship between Ln Maruti and Ln Nifty
The coefficient β1 in a log-linear model represent the estimated percent change in the
dependent variable for a unit change in the independent variable.
If β1 > 0, it indicates that the dependent variable increases exponentially which a unit
increase in the independent variable. Thus, there is a positive relationship between the
dependent and the independent variable which is depicted by an upward sloping curve.
If β1 < 0, it indicates that the dependent variable decreases exponentially which a unit
increase in the independent variable. Thus, there is a negative relationship between the
dependent and the independent variable which is depicted by a downward sloping curve.
Analysis: To study the log – lin model, we study the impact of the independent variable (P/E
ratio, P/E ratio and Dividend Yield of Nifty) on the dependent variables (log of Nifty). The
data for all the variables has been taken for 5 years. The regression equation has been taken
to be
Ln (Nifty) = β0 + β1*PE + β2*PB + β3*Div_Yield + µi
The value of β1 is 0.0628 which implies that a unit increase in P/E ratio will cause a 6.28%
increase in the Ln nifty. The value of β2 is -0.0679 which implies that a unit increase in P/B
ratio will cause a 6.79% fall in Ln Nifty. The value of β3 is 0.0156 which implies that a unit
increase in Dividend Yield will cause a 1.56% increase in the Ln nifty.
Lin – Log Model
Lin – Log model is another form of semi – log models, which is obtained by taking the
dependent variable in its linear form while taking the log of the independent variable. The
lin – log model is suitable when the impact of your independent variable on your dependent
variable decreases as the value of your independent variable increases. It is also suitable in
the cases when the dependent variable is extremely sensitive to changes in the independent
variable.
A suitable example of the Lin – Log model is the impact of interest rates on the amount of
investment in the economy. Any change in the rates of interest will have a significant
impact on the amount of investment. As the interest rate increases, the cost of the
investments increases and thus the amount of investment falls.
This can be depicted by the following model
Yi = β0 + β1*(ln Xi) + µi
Where Yi = Amount of Investment, Xi = Rate of Interest
On differentiating both sides, we observe that
Rate of change in Y = β1.(Rate of change in ln Xi)
δY = β1.(δX/X)
Elasticity = (δY/Y)/ (δX/X) = β1.(1/X)
Slope = Change in Y / Change in X = β1.(1/Y)
It can be observed that the elasticity and the slope of the model are not constant and vary
throughout the model. The elasticity is inversely proportional to the independent variable
whereas the slope is inversely proportional to the dependent variable. This implies that
elasticity and slope are not independent of the variables. Regression coefficients do not
represent the elasticity or slope in the lin – log model.
This is a mathematical form in which the inverse of the independent variable is taken and its
impact is estimated on the dependent variable. The reciprocal model is suitable in case the
dependent variable approaches the intercept term when the independent variable increases
indefinitely. As the independent variable approaches to infinity, its inverse i.e. 1/Xi
approaches zero. And thus, the dependent variable approaches the limiting value of β0.
When β1 > 0, the value of Y falls and approaches β0, whereas when β1 < 0, the value of Y
increases and approaches β0. Because the slope is a function of 1/X, the slope gets flatter as
X increases.
The reciprocal function is sometimes used to estimate demand curves. The reciprocal model
is also suitable in case of the Engel expenditure curve
Polynomial Model
Polynomial Regression is a form of linear regression in which the relationship between the
independent variable x and dependent variable y is modelled as an nth degree polynomial.
The independent variables which are raised to a power such as square (2) or cube (3) are
termed as polynomial variables.
Under the polynomial model, the dependent variable is regressed on a number of
independent variables which are higher powers of the same variable. It is of the form
Yi = β0 + β1xi + β2x2i + β3x3i + µi
This is the structural form of the third order polynomial model or the cubic model
The polynomial model is suitable in cases where the relationship between dependent and
explanatory variables is curvilinear i.e. it is not uniform.
An example of the quadratic model is the short run marginal cost curve. As we know,
initially the marginal cost falls with increase in the quantity produced as the marginal
product increases (due to increasing returns). Then as marginal product falls due to the law
of diminishing returns, marginal cost increases with increase in quantity produced, which
leads to a U - shaped Marginal cost curve.
The equation of the marginal cost curve can be formulated with a polynomial model of
second order:
MC = β0 + β1.Q + β2.Q2 + µi
2. Underlying Theory:
The functional form of the regression model can also be chosen on the basis of the
underlying theory. For example, in the study of price elasticity of demand, elasticity
measures the percentage change in quantity demanded due to percentage change in
price. This type of relationship can be best suited for a Log – Log model. Similarly, the
production function first increases at an increasing rate and then decrease at a
diminishing rate and this relationship can be suited with a third - degree polynomial
form (cubic model).
3. Slope and Elasticity:
The rate of change in the dependent variable due to the independent variable
(slope) and the elasticity between the two variables can also be used to choose the
right functional form for the model. For instance, of the slope of the regression
model is constant, then the linear functional form is suitable whereas if the value of
elasticity is constant throughout the model, then the Log – Log model is suitable for
the regression analysis
4. Adjusted R2:
Different functional forms can be fitted to the data to select the functional form
which best suites the data. The best functional form can be selected on the basis of
the value of adjusted R2. The functional form which gives a higher value of adjusted
R2 is better suited for the model.
But it should be taken into consideration that while comparing the values of
adjusted R2 of the different functional forms, the dependent variable of the
functional forms should be the same. This implies that the log – log model and the lin
– log model cannot be compared on the basis of value of adjusted R2 because the
dependent variables in the two functional forms differ.