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Portfolio Management and Performance Evaluation: 4321

University of Minnesota October 24, 2019


Professor Erik Loualiche (eloualic@umn.edu) Problem Set 1

Portfolio Management and Performance Evaluation

Homework 1-answers.

Question 1 (Simple Linear Regression) (5 points)

σ
(a) FALSE. By definition, in a linear regression Yt = α+ β × Xt , we have β = σy,x 2 (where σy,x is
x
the covariance between Y and X) . By definition of correlation between y and x (ρy,x ) we have
σy,x
ρy,x = σy ×σ x
which implies σy,x = ρy,x × σy × σx . Substitute this in the definition of beta we have
ρ ×σ ×σ ρy,x ×σy σy
β = y,x σ2y x = σx . Thus if ρy,x = 1, we have β = σx which in general is not 1 because in
x
general σx 6= σy .
ρ ×σ ×σ
(b) TRUE Doing the same algebra steps as in the previous question, we have β = y,x σ2y x . Thus if
x
ρy,x = 0, we have β = 0. Zero correlation means that knowing what happened to X tells nothing about
Y , and thus the regression will not have any predictive power as well.

(c) FALSE. Recall the definition of R2 (a measure of the predictive power of x)

β 2 σx2
R2 =
σy2

and clearly, if R2 = 1, then it does not have to be the case that β = 1 (only if σx2 = σy2 which in general
is not the case)

(d) TRUE. Now, using the previous definition of R2 , because σx2 > 0, we must have that if R2 = 0 then
β = 0. Intuition is that the regression with no predictive power should have β = 0, since knowing X
does not give any information about Y .

(e) FALSE. If R2 = 1, the regression explains all the variance in Y . This means that X is perfectly
predicting Y . However, their correlation does not have to be equal to one for that: if the correlation is
−1, the prediction is also perfect, but the two random variables move exactly in opposite directions.
In fact, you can show that R2 = ρ2y,x using the definition of the R2 and the expression for β obtained
in part (a),
2 2
β 2 σx2

2 σy σx
R = 2
= ρy,x × = ρ2x,y
σy σx σy2

Question (2) (Run a Regression in Excel) (5 points)


The Excel file is DataHomework1 Question2 answers.xls available on the course webpage contains the re-
gression output.

(a) The percentage of the variance of the returns of T.J. Maxx that is explained by the return of the
Market is given by the R2 of the regression Here the R2 = 0.25 which means that 25% of the variance
of the return of T.J. Maxx are explained by the Market returns.
2 Handout 1: Portfolio Management and Performance Evaluation

(b) In this regression we estimate α = 0.008. This means that when the return on the market is 0%, the
average return of T.J. Maxx is 0.008%. This value is statistically significant since the t-statistic is 2.19
which is greater than 1.96. This means that α is statistically different from zero.
(c) In this regression we estimate β = 1.25. This means that when the return on the market increase in 1%,
on average, the return of T.J. Maxx increases in 1.25%. This value is clearly statistically significant
since the t-statistic is 14.66 which is significantly greater than 1.96. This means that β is statistically
different from zero.

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