Introductory Econometrics: A Modern Approach 6th Edition by Jeffrey M Wooldridge

Exercise 17

Use the data in VOLAT.RAW for this exercise. The variable rsp500 is the monthly return on the Standard&Poor's 500 stock market index, at an annual rate. (This includes price changes as well as dividends.) The variable i3 is the return on three-month T-bills, and pcip is the percentage change in industrial production; these are also at an annual rate.

(i) Consider the equation

. What signs do you think $1 and $2 should have?

(ii) Estimate the previous equation by OLS, reporting the results in standard form. Interpret the signs and magnitudes of the coefficients.

(iii) Which of the variables is statistically significant?

(iv) Does your finding from part (iii) imply that the return on the S&P 500 is predictable? Explain.

Step 1 of 4

(i)

In the regression model:

Where the monthly return on the Standard & Poor’s 500 stock market index, at an annual rate

The percentage change in industrial production, at annual rate

The return on three-month T-bills

Since, the monthly annualized rate of return on the Standard & Poor’s 500 stock market index would increase with the increased industrial production due to increased profitability and hence, increased dividend declaration and high market sentiments in favor of the stocks related to industrial goods, it would help the monthly return on the Standard & Poor’s 500 stock market index to respond positively to the return on three-month T-bills.

Since, the T-bills are the close substitute of the stocks, so an increase in the return on T-bills would attract funds from the stocks to the T-bills, thereby implying that the monthly return on the Standard & Poor’s 500 stock market index respond negatively to the increase in return on T-bills.

Thus, it is expected that will be positive sign and will be with negative sign