Lec 1 - research in finance and essentials of econometrics

Question 1

What is theoretical research?

Answer 1

A system of ideas trying to explain something, especially one based on general principles of the objects trying to be explained:
- On average
- In principle
- Probability

Question 2

What are examples of theoretical research in the real world?

Answer 2

Relation between individual stock return and market return
CAPM

Question 3

What is empirical research?

Answer 3

Empirical means verifiable by observations, experiences, and evidence (rather than theory)

Question 4

What do you test in empirical analysis?

Answer 4

Predictions of a theory
- When findings are consistent with theory’s predictions, you have good level of confidence to believe the theory is right
- When findings are inconsistent with predicitions, a theory is rejected

Question 5

What is a clinical study?

Answer 5

A study based on 1 case (you can have more than once company e.g a takeover has 2)
- Disney’s takeover of Marvel
- Marvel’s IPO
- Steve Job’s death in 2012

Question 6

What are the benefits and drawbacks of clinical study?

Answer 6

Benefit:
- In-depth analysis is possible
Drawback:
Difficult to generalise to a broader group

Question 7

What is a good example of a clinical study?

Answer 7

Lys and Vincent 1995

Question 8

What is a large sample study?

Answer 8

Based on a large sample of similar cases
- Sample of IPO companies
- Sample of bidders in M&A transactions
Answers questions:
- What’s the average long-term performance of IPO firms?
- On average do bidders gain or lose?

Question 9

What are the benefits and drawbacks of large sample study?

Answer 9

Benefit:
- Can make general conclusions
Drawback:
- Costly to conduct very detailed analyses of each case

Question 10

What is a good example of a large sample study?

Answer 10

Gregory 1999 and Gao 2011

Question 11

What is a Steve Jobs example of hypothesis testing?

Answer 11

The event would have negative impact on share price
Null: Apple’s (abnormal) share return on 5th Oct is non-negative
Alternative: Apple’s (abnormal) share return on 5th Oct is negative

Question 12

How to test the Steve Jobs hypothesis?

Answer 12

Event study methodology
- Reject null in favour of alternative hypothesis, if Apple’s abnormal return is significantly negative upon the announcement
- Fail to reject the null hypothesis, if Apple’s abnormal return is insignificant or significantly positive upon the announcement
- One-tailed test

Question 13

When do you perform a one-tailed test?

Answer 13

When the hypotheised value deviates from the null in only one direction

Question 14

When do you perform a two-tailed test?

Answer 14

If the hypothesised value may deviate from the null in either direction

Question 15

What are the characteristics of a two-tailed test?

Answer 15

• Stricter
• Fixed significance level - if a hypothesis is rejected in a two-tailed test, it must be rejected in a one-tailed test, ceteris parabus (this doesn’t work the other way)

Question 16

When can a null hypothesis get rejected?

Answer 16

With a confidence level less than 100%
- Required level of confidence is 95% or 99% (99% being higher)

Question 17

What is a random variable?

Answer 17

Numerical realisation of an underlying distribution
- Distribution that consists of the possible outcomes and their respective probabilities (stock return of the next day)
- Beta and abnormal returns are random variables

Question 18

What is statistical significance?

Answer 18

Level of signifiance = 1 - level of confidence
E.g:
Statistical significance 1% = 99% level of confidence
Statistical signifiance 5% = 95% level of confidence
1% is a higher level of statistical significance

Question 19

How do you test statistical significance?

Answer 19

Compare the test statistic and the critical value

Question 20

What are the test statistics for a random variable?

Answer 20

A figure that summarises the information in the data on the random variable
- Reduces all information to a figure to draw inferences
- Is also a random variable
- Formula given by staticians

Question 21

What is the critical value?

Answer 21

A specific value on the support of the distribution of the test statistic

Question 22

What happens when a test statistic falls beyond a critical value?

Answer 22

• Reject the null hypothesis at the corresponding level of significance

Question 23

Why does the critical value vary?

Answer 23

• Type of distributions random variable follows
• Type of test (one or two-tailed)
• Degrees of freedom of data

Question 24

What is a type 1 error?

Answer 24

When you reject a null hypothesis that is true

Question 25

What is a type 2 error?

Answer 25

When you fail to reject a null hypothesis that is false

Question 26

What is the power of test?

Answer 26

Measures the power of test in picking up the hypothesised effect
If a test has high (low) power, it has a low (high) probability of making a type 2 error

Question 27

How is the power of test measured?

Answer 27

Measured by 1 - Probability of making a type 2 error