The impact of monetary policy on stock prices


Word Limit 2500 words (excluding appendix and reference list)

You have been allocated monthly time-series data for the United States over the period January 1980-December2009. The data refer to the following:


S :the nominal stock price of a given company;

FED:the nominal short-term interest rate, measured by the effective federal funds ratea (yields in percentage per annum);

IP :the level of industrial production.

Let NSRt be the monthly stock returns of the assigned company. Consider the following regression model:

NSRt = β1 + β2 · FEDt + ut,

where FEDt is assumed to be a stationary series.

1.Report the time series plots ofthe series and the scatter plot. Comment on the graphs.

2. Use Ordinary Least Squares (OLS) to estimate the regression model (1). Report and discuss your results with reference to the Present Value Theory, also known as Discounted Cash Flow Modelb.

3. Plot the actual values, the fitted values and the residuals and comment on the model fitting.

4. Analyze the regression output applying the appropriate diagnostic tools. Will your answer for question 2 remain the same when
potential diagnostic problems are taken into account?

5. The most intense period of the recent financial crisis lasted between September 2007 and March 2009. Test whether the relationship between stock returns and interest rate has been affected by the financial crisis, i.e. if the relationship before and during the crisis can be considered statistically different.

Consider the following extension of Model:

NSRt = β1 + β2 · FEDt + β3 · GINDt + ut

where GINDt is the monthly growth rate of the industrial production.

6.Use OLS to estimate the above relationship and report the results. Compare the fit of the two alternative models (Model(1) and Model(2)) and comment.

7.Test the joint hypothesis that: H0 : β2 = β3 = 0 at the 5% level of significance and comment on the test outcome.


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