The book-to-market ratio and the size of a company's equity are two factors that have been asserted to be useful in explaining the cross-sectional variation in subsequent returns. Based on this assertion, you want to estimate the following regression model:

Where
R i = Return of company i's shares (in the following period)
(Book/Market) i = company i's book-to-market ratio
Size i = Market value of company i's equity
A colleague suggests that this r egression specification may be erroneous, because he believes that the book-to-market ratio may be strongly related to (correlated with) company size.
A. To what problem is your colleague referring, and what are its consequences for regression analysis?
B. With respect to multicollinearity, critique the choice of variables in the regression model above.

C. State the classic symptom of multicollinearity and comment on that basis whether multicollinearity appears to be present, given the additional fact that the F-test for the above regression is not significant.

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Book R; = b, + b, + b,Sizc, +E; Market Regression of Return on Book-to-Market and Size Standard Error 4.220 -Statistic Coefficient Intercept 3.3427 14.1062 Book Market -1.3430 -12.1413 9.0406 Size; -0.00005502 -0.92047 0.00005977 0.06156 R-squared Observations 34