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Question Bl (20 marks) In the paper on the Overreaction Hypothesis and the UK Stock Market by Clare and Thomas (1995), the authors employed monthly

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Question Bl (20 marks) In the paper on the "Overreaction Hypothesis and the UK Stock Market" by Clare and Thomas (1995), the authors employed monthly UK stock returns from January 1955 to December 1990 on all firms traded on the London Stock exchange to run a regression RD1 = ate , (B1-1) where Roy = Roy - Roy, R denotes the monthly average excess return over the stock market and t denotes the 18 independent tracking periods. Ry, and Roy are the loser's and winner's portfolio returns respectively. (a) State the overreaction hypothesis and how can one use regression (B1-1) to test for the overreaction hypothesis? [2] (b) Suppose the loser stocks are generally more risky, explain the drawback of using regression (B1-1) when testing the overreaction hypothesis. How would you correct for it? [2] Using the data employed by Clare and Thomas (1995), suppose you are interested in analyzing whether there are quarterly return differences between the loser and winner portfolios. You estimated the following regression by OLS: (B1-2)where Roy =Roy - Roy, R denotes monthly excess return over the stock market, O; is a dummy variable for i=1, 2 and 3 such that O, =1 if return is in the i-th quarter and 0 otherwise. The result is a = 0.02, #1 = 0.01, 82 =-0.005, 6; = 0.03, RSS= 680.0 (c) What is the difference in the mean return between the first and second quarter? [1] (d) Now define a fourth quarter dummy as 94/ =1 if return is in the fourth quarter and 0 otherwise. Suppose you drop the first quarter dummy from regression (B1-2) and include the fourth quarter dummy instead such that Ros = a+ B.Q4 + 8102, + Pilar+ e, (B1-3) What will the estimated value of a, B., B,, 8, now be? [4] (e) Can one run the following regression (B1-5) i-1 to analyse whether there are quarterly return differences between the loser and winner portfolio? Explain. [2]

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