© CFA Institute.

The following information relates to Questions 1–9

Max Busse is an analyst in the research department of a large hedge fund. He was
recently asked to develop a model to predict the future exchange rate between
two currencies. Busse gathers monthly exchange rate data from the most recent
10-year period and runs a regression based on the following AR(1) model specification:

Regression 1: xt = b
 0 + b1xt–1 + εt, where xt is the exchange rate at time t.

Based on his analysis of the time series and the regression results, Busse reaches the
following conclusions:

Conclusion 1: The variance of xt increases over time.

Conclusion 2: The mean-reverting level is undefined.

Conclusion 3: b0 does not appear to be significantly different from 0.

Busse decides to do additional analysis by first-differencing the data and running a

new regression.

Regression 2: yt = b0 + b1yt–1 + εt, where yt = xt – xt–1.

Exhibit 1 shows the regression results.

Exhibit 1. F
 irst-Differenced Exchange Rate AR(1) Model: Month-End Observations,
Last 10 Years

Regression Statistics
R2 0.0017
Standard error 7.3336
Observations 118
Durbin–Watson 1.9937

Coefficient Standard Error t-Statistic

Intercept –0.8803 0.6792 –1.2960
xt–1 – xt–2 0.0412 0.0915 0.4504

Autocorrelations of the Residual

Lag Autocorrelation Standard Error t-Statistic

1 0.0028 0.0921 0.0300
2 0.0205 0.0921 0.2223
3 0.0707 0.0921 0.7684
4 0.0485 0.0921 0.5271
Note: The critical t-statistic at the 5% significance level is 1.98.
Busse decides that he will need to test the data for nonstationarity using a Dickey–Fuller
test. To do so, he knows he must model a transformed version of Regression 1.

Busse’s next assignment is to develop a model to predict future quarterly sales for
PoweredUP, Inc., a major electronics retailer. He begins by running the following
regression:

Regression 3: ln Salest – ln Salest–1 = b0 + b1(ln Salest–1 – ln Salest–2) + εt.

Exhibit 2 presents the results of this regression.

Exhibit 2. L
 og Differenced Sales: AR(1) Model PoweredUP, Inc.,
Last 10 Years of Quarterly Sales

Regression Statistics
R2 0.2011
Standard error 0.0651
Observations 38
Durbin–Watson 1.9677

Coefficient Standard Error t-Statistic

Intercept 0.0408 0.0112 3.6406
ln Salest–1 – ln Salest–2 –0.4311 0.1432 –3.0099

Autocorrelations of the Residual

Lag Autocorrelation Standard Error t-Statistic

1 0.0146 0.1622 0.0903
2 –0.1317 0.1622 –0.8119
3 –0.1123 0.1622 –0.6922
4 0.6994 0.1622 4.3111
Note: The critical t-statistic at the 5% significance level is 2.02.
Because the regression output from Exhibit 2 raises some concerns, Busse runs a
different regression. These regression results, along with quarterly sales data for the past
five quarters, are presented in Exhibits 3 and 4, respectively.

Exhibit 3. L
 og Differenced Sales: AR(1) Model with Seasonal Lag PoweredUP, Inc.,
Last 10 Years of Quarterly Sales

Regression Statistics
R2 0.6788
Standard error 0.0424
Observations 35
Durbin–Watson 1.8799

Coefficient Standard Error t-Statistic

Intercept 0.0092 0.0087 1.0582
ln Salest–1 – ln Salest–2 –0.1279 0.1137 –1.1252
ln Salest–4 – ln Salest–5 0.7239 0.1093 6.6209

Autocorrelations of the Residual

Lag Autocorrelation Standard Error t-Statistic

1 0.0574 0.1690 0.3396
2 0.0440 0.1690 0.2604
3 0.1923 0.1690 1.1379
4 –0.1054 0.1690 –0.6237
Note: The critical t-statistic at the 5% significance level is 2.03.
Exhibit 4. Most Recent Quarterly Sales Data (in billions)

Dec 2015 (Salest–1) $3.868

Sept 2015 (Salest–2) $3.780

June 2015 (Salest–3) $3.692

Mar 2014 (Salest–4) $3.836

Dec 2014 (Salest–5) $3.418

After completing his work on PoweredUP, Busse is asked to analyze the relationship of
oil prices and the stock prices of three transportation companies. His firm wants to know
whether the stock prices can be predicted by the price of oil. Exhibit 5 shows selected
information from the results of his analysis.

Exhibit 5. A
 nalysis Summary of Stock Prices for Three Transportation Stocks and
the Price of Oil

Serial
Correlation
Linear or of Residuals
Unit Exponential in Trend
Root? Trend? Model? ARCH(1)? Comments
Not co-integrated
Company #1 Yes Exponential Yes Yes
with oil price
Co-integrated with
Company #2 Yes Linear Yes No
oil price
Not co-integrated
Company #3 No Exponential Yes No
with oil price

Oil Price Yes

To assess the relationship between oil prices and stock prices, Busse runs three
regressions using the time series of each company’s stock prices as the dependent
variable and the time series of oil prices as the independent variable.
1. Which of Busse’s conclusions regarding the exchange rate time series is consistent
with both the properties of a covariance-stationary time series and the properties of
a random walk?
A. Conclusion 1.
B. Conclusion 2.
C. Conclusion 3.

2. Based on the regression output in Exhibit 1, the first-differenced series used to run
Regression 2 is consistent with:
A. a random walk.
B. covariance stationarity.
C. a random walk with drift.

3. Based on the regression results in Exhibit 1, the original time series of

exchange rates:
A. has a unit root.
B. exhibits stationarity.
C. can be modeled using linear regression.

4. In order to perform the nonstationarity test, Busse should transform the

Regression 1 equation by:
A. adding the second lag to the equation.
B. changing the regression’s independent variable.
C. subtracting the independent variable from both sides of the equation.

5. Based on the regression output in Exhibit 2, what should lead Busse to conclude
that the Regression 3 equation is not correctly specified?
A. The Durbin–Watson statistic.
B. The t-statistic for the slope coefficient.
C. The t-statistics for the autocorrelations of the residual.

6. Based on the regression output in Exhibit 3 and sales data in Exhibit 4, the
forecasted value of quarterly sales for March 2016 for PoweredUP is closest to:
A. $4.193 billion.
B. $4.205 billion.
C. $4.231 billion.
 7. Based on Exhibit 5, Busse should conclude that the variance of the error terms for
Company #1:
A. is constant.
B. can be predicted.
C. is homoskedastic.

8. Based on Exhibit 5, for which company would the regression of stock prices on oil
prices be expected to yield valid coefficients that could be used to estimate the
long-term relationship between stock price and oil price?
A. Company #1.
B. Company #2.
C. Company #3.

9. Based on Exhibit 5, which single time-series model would most likely be appropriate
for Busse to use in predicting the future stock price of Company #3?
A. Log-linear trend model.
B. First-differenced AR(2) model.
C. First-differenced log AR(1) model.

1. C C is correct. A random walk can be described by the equation

xt = b0 + b1xt–1 + εt, where b0 = 0 and b1 = 1. So b0 = 0 is a characteristic of a
random walk time series. A covariance-stationary series must satisfy the
following three requirements:

1. The expected value of the time series must be constant and finite in all periods.

2. The variance of the time series must be constant and finite in all periods.

3. The covariance of the time series with itself for a fixed number of periods in the
past or future must be constant and finite in all periods.

b0 = 0 does not violate any of these three requirements and is thus consistent with
the properties of a covariance-stationary time series.
2. B B is correct. The critical t-statistic at a 5% confidence level is 1.98. As
a result, neither the intercept nor the coefficient on the first lag of the first-
differenced exchange rate in Regression 2 differs significantly from zero. Also,
the residual autocorrelations do not differ significantly from zero. As a result,
Regression 2 can be reduced to yt = εt, with a mean-reverting level of b0/(1 – b1) =
0/1 = 0.

Therefore, the variance of yt in each period is var(εt) = σ2. The fact that the residuals
are not autocorrelated is consistent with the covariance of the times series with
itself being constant and finite at different lags. Because the variance and the
mean of yt are constant and finite in each period, we can also conclude that yt is
covariance stationary.

3. A A is correct. If the exchange rate series is a random walk, then the first-
differenced series will yield b0 = 0 and b1 = 0 and the error terms will not be
serially correlated. The data in Exhibit 1 show that this is the case: Neither the
intercept nor the coefficient on the first lag of the first-differenced exchange
rate in Regression 2 differs significantly from zero because the t-statistics of
both coefficients are less than the critical t-statistic of 1.98. Also, the residual
autocorrelations do not differ significantly from zero because the t-statistics of
all autocorrelations are less than the critical t-statistic of 1.98. Therefore, because
all random walks have unit roots, the exchange rate time series used to run
Regression 1 has a unit root.

4. C C is correct. To conduct the Dickey–Fuller test, one must subtract the

independent variable, xt–1, from both sides of the original AR(1) model. This
results in a change of the dependent variable (from xt to xt – xt–1) and a change
in the regression’s slope coefficient (from b1 to b1 – 1) but not a change in the
independent variable.

5. C C is correct. The regression output in Exhibit 2 suggests there is serial

correlation in the residual errors. The fourth autocorrelation of the residual has
a value of 0.6994 and a t-statistic of 4.3111, which is greater than the t-statistic
critical value of 2.02. Therefore, the null hypothesis that the fourth autocorrelation
is equal to zero can be rejected. This indicates strong and significant seasonal
autocorrelation, which means the Regression 3 equation is misspecified.
6. C C is correct. The quarterly sales for March 2016 are calculated as follows:

ln Salest – ln Salest–1 = b0 + b1(ln Salest–1 – ln Salest–2) + b2(ln Salest–4 – ln Salest–5).

ln Salest – ln 3.868 = 0.0092 – 0.1279(ln 3.868 – ln 3.780) + 0.7239(ln 3.836 – ln 3.418).

ln Salest – 1.35274 = 0.0092 – 0.1279(1.35274 – 1.32972) + 0.7239(1.34443 – 1.22906).

ln Salest = 1.35274 + 0.0092 – 0.1279(0.02301) + 0.7239(0.11538).

ln Salest = 1.44251. Salest = e1.44251 = 4.231.

7. B B is correct. Exhibit 5 shows that the time series of the stock prices of
Company 1 exhibits heteroskedasticity, as evidenced by the fact that the time
series is ARCH(1). If a time series is ARCH(1), then the variance of the error in one
period depends on the variance of the error in previous periods. Therefore, the
variance of the errors in period t + 1 can be predicted in period t using the formula

σˆ t2+1 = aˆ 0 + aˆ 1εˆ t2

8. B B is correct. When two time series have a unit root but are cointegrated,
the error term in the linear regression of one time series on the other will be
covariance stationary. Exhibit 5 shows that the series of stock prices of Company 2
and the oil prices both contain a unit root and the two time series are cointegrated.
As a result, the regression coefficients and standard errors are consistent and can
be used for hypothesis tests. Although the cointegrated regression estimates the
long-term relation between the two series, it may not be the best model of the
short-term relationship.

9. C C is correct. As a result of the exponential trend in the time series of stock

prices for Company 3, Busse would want to take the natural log of the series and
then first-difference it. Because the time series also has serial correlation in the
residuals from the trend model, Busse should use a more complex model, such as
an autoregressive (AR) model.