Questions and Answers of Introductory Econometrics Modern

4 See Block and Vaaler (2004) and Cardinale (2007), respectively.
3 We discuss spread cointegration later in the chapter.
2 Unlike the Federal Reserve, the ECB does not announce an explicit target for its operational implementation of the monetary policy stance in the euro area. Instead, it provides refinancing to the
1 The nine macro variables were: industrial production, unemployment rate, capacity utilization, employment, housing starts, retail sales, personal income, durable orders and consumption.
5 How do interest rate changes affect exchange rates? What is the chain of events?
4 If you engaged in a foreign exchange transaction without a forward contract, what would that imply about you, as an investor?
3 Can you give an intuitive explanation of the link between stock market variations (volatility) and credit spreads?
2 What would you expect a low-interest-rate currency to do vs. high-interest-rate currencies? Can you explain it?
1 What could happen to credit spreads when investors ‘reach for higher yield’, in a low interest-rate environment? What does it mean?
10 Define the following terms: simultaneity bias, exogeneity and its variants.
9 What is the forward premium puzzle? Provide some evidence.
8 Explain the law of one price, the interest-rate parity, the covered interest rate parity and the uncovered interest rate parity.
7 Why is evidence or absence of cointegration among spreads important?
6 What are limited-dependent variables models? Give some examples of these models.
5 What about the yield spread’s power to explain economic activity? Provide some empirical evidence.
4 What about the predictive ability of the yield curve spread regarding recessions?Summarize some findings.
3 Campbell and Shiller (1991) examine whether the slope of the term structure predicted future changes in interest rates. Summarize their findings.
2 Can the term structure explain movements in inflation and economic activity?Summarize the findings by Estrella and Mishkin (1998).
1 What do the G-spread, I-spread and TED-spread represent for an investor?
● Econometric methodologies for exchange rates, simultaneous equations, VAR/VEC models, 2SLS and IV models
● The forward premium puzzle
● Important laws of exchange rate and empirical evidence
● Econometric methodologies for exchange rates, limited-dependent variables models (logit, probit), multinomial models (ordered and unordered logit/probit)
● The economic significance of yield spreads
● Bond yields and spreads
4 The seminal empirical work of Litterman and Scheinkman (1991) has led to the identification and conclusion that these three factors are required to explain the movements of the whole term structure
3 An arbitrage opportunity exists in a market model if there is a strategy that only guarantees a positive payoff and no initial net investment. The presence of arbitrage opportunity is inconsistent
2 A stochastic process that, on average, increases/decreases is called a submartingale/supermartingale.
1 Asset prices are determined by expectations about the paths of future economic variables. The ‘Peso problem’ focuses upon how asset prices behave when market traders have expectations about
5 Why is there a disconnect between finance and the macroeconomy in the way the short-term interest rate is modeled?
4 Give an economic rationale why long and short Treasury bill term spreads tend to follow the business cycle. (Hint: think of what happens to the term premiums, which are the reward for extending
3 If expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve?
2 If the yield curve suddenly became steeper, how would you revise your predictions of interest rates in the future?
1 How might a sudden increase in people’s expectations of future real estate prices affect interest rates?
10 Why is a practical understanding of the stochastic behavior of bond rates and yields or, the yield curve, by extension, important?
9 What is the main difference between an equilibrium and a no-arbitrage interest rate model?
8 What is a short-rate model, what is its purpose and what is the main assumption of the one-factor and multifactor short rate models?
7 What would be the impact of the COVID-19 global pandemic on the term structure, monetary policy and global asset markets?
6 How does the reduced liquidity of corporate bonds affect their interest rates relative to the interest rate on Treasury bonds?
5 Why do tests of the expectations hypothesis fail to support it during turbulent periods, such as that from 1979 to 1982 in the US?
4 If bond investors decide that 30-year bonds are no longer as desirable an investment, what will happen to the yield curve, assuming (a) the expectations theory and (b) the segmented markets theory
3 Predict what will happen to interest rates on a corporation’s bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will
2 Predict what will happen to interest rates if investors suddenly expect a large increase in stock prices. Predict what will happen to interest rates if prices in the bond market become more
1 The more risk averse people are, the more likely they are to diversify. Is this statement true, false, or uncertain? Explain.
(d) Valuation of mortgages, credit instruments, bonds and other derivatives that are sensitive to interest rates
(c) Valuation of real assets/capital of businesses and capital/asset adequacy of financial institutions
(b) The US Generally Accepted Accounting Principles (GAAP): which requires valuations of products, with a significant exposure to interest rates, under various risky scenarios
(a) In the insurance/actuarial industry: valuation of annuities with guaranteed benefits such as Guaranteed Investment Contract (which is a contract between an investor and an insurance company)
3 The higher inflation rate that can result from an increase in the money supply can also affect interest rates by influencing the expected inflation rate. This increase in expected inflation will
2 An increase in the money supply can also cause the overall price level in the economy to rise. The liquidity preference framework predicts that this will lead to a rise in interest rates. Thus, the
An increasing money supply can cause national income and wealth to rise. Both the liquidity preference and bond supply and demand frameworks indicate that interest rates will then rise. Thus, the
3 Profitable investment opportunities. With such opportunities, firms are more willing to borrow to finance these investments. When the economy is growing rapidly, investment opportunities that are
2 Budget deficits. The government’s activities can influence the supply of bonds in several ways. The US Treasury issues bonds to finance government deficits, caused by gaps between the
1 Expected inflation. For a given interest rate (and bond price), when expected inflation rises, the real cost of borrowing falls. As a result, the quantity of bonds supplied increases at any given
● Some empirical evidence
● Interest rate models (one-factor and multifactor models)
● The shapes of the yield curve
liquidity preference hypothesis, market segmentation hypothesis and preferred habitat models)
● The behavior of interest rates
● Theories of interest-rate determination (loanable funds and liquidity preference theory)
● Some empirical evidence
● Interest rate models (one-factor and multifactor models)
● The shapes of the yield curve
● The various models of the term structure (the pure expectations hypothesis, liquidity preference hypothesis, market segmentation hypothesis and preferred habitat models)
● The behavior of interest rates
● Theories of interest-rate determination (loanable funds and liquidity preference theory)
6 What would be the effect of liquidity on an asset’s expected return?
5 Why is the general version of the Arbitrage Pricing Theory (APT) offering the greatest advantage over the simple CAPM?
4 We know that the APT does not provide guidance concerning the factors used to determine risk premiums. How would you then decide if some variables such as industrial production would be a
3 If a portfolio manager changes one security with another in a well-diversified portfolio, what would be the impact of such a change on that portfolio’s return?
2 How can factor betas provide a framework for a hedging strategy?
1 Suppose you expected GDP to increase by 3% next year but it actually increased by 2%. What impact would that difference have in a factor model where GDP was included?
11 Why do we need to correct for heteroscedasticity and serial correlation in the regression residuals?
10 Explain the role of liquidity in the Pástor-Stambaugh multifactor model.
9 Explain how Fama and French (1993) expanded their three-factor model and discuss their econometric methodology.
8 Briefly describe the Chen et al. (1986) paper and its findings.
7 List and briefly explain some potential uses/applications of APT.
6 Describe the Arbitrage Pricing Theory in one paragraph.
5 Which methods have been used in the empirical literature to identify the appropriate number of factors to include in a multifactor model?
4 What are the differences between factor analysis and principal component analysis in factor construction?
3 Which are the different categories of multifactor models, and what are their characteristics?
2 Why are multifactor models necessary? Is the traditional CAPM not good enough?
What is a factor? What is its difference from a variable? Give some examples of factors.
● A linear factor model can be used to describe the relation between the risk and return of a security.● Idiosyncratic risk can be diversified away in a well- diversified asset portfolio. The
● Some final comments on multifactor models
● Some econometric methodologies (GLS, quantile regression, rolling regression)
● Some econometric issues (heteroscedasticity, serial correlation)
● Other multifactor models
● Important multifactor models
● Some notable APT applications
● The Arbitrage Pricing Theory
● Some empirical evidence
● Ways to determine the number of factors
● Factor and principal components analyses
● Factor-construction methodologies (time-series and cross-section)
● Categories of factor models (macroeconomic fundamental, statistical)
4 The constant-growth dividend discount model is P0 = D1 /(k − g), where P0 is the stock’s current price, D1 is the expected dividend, k is the investor’s required rate of return and g is the
3 Note that in Box 7.2 we used λ instead of γ.
2 We will discuss the instrumental variable (IV) regression approach in Chapter 10.
1 One could modify the equation by dropping the scaling factor and use σ instead of σ2.

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