Rift Valley University

Bole Campus
Department of Accounting and Finance

Basic Econometrics for Finance (Econ 602)

By: Mekonnen Bersisa (PhD)

[email protected]

Assistant professor of Economics

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 1.1 DEFINITION AND SCOPE OF ECONOMETRIC
 What is Econometrics?
 Literal meaning …. measurement in economics,
……………..or economic measurements.
 We measure economic relationships: stock price, employment,
money supply, tax revenue, exports, imports, price indexes etc.
 It comes from two Greek words: Economia-economy and metron-
measure.

 Definition of financial econometrics:

The application of statistical and mathematical techniques to problems in
finance.
 More specifically,
 Econometrics is the application of statistical and mathematical
methods to the analysis of economic data with a purpose of giving
an empirical content to economic theories and verifying them or
refuting them.
 It is also defined as the quantitative analysis of actual economic
phenomenon based on the concurrent development of theory and
observation related by appropriate methods and inferences. 2
 WORKING DEFINITION OF ECONOMETRICS
 Econometrics is defined as the quantitative analysis of
actual economic phenomenon based on the concurrent
development of theory and observation related by
appropriate methods and inferences.
 Econometrics is concerned with the application of
mathematical statistics to economic data to lend
empirical support to the models constructed by
mathematical economics to obtain numerical result.
 Econometrics is concerned with estimating parameters
and testing a theoretical propositions embodied in
economic relationships.
 Econometrics is the scientific approach that aims at a
conjunction of econometric theory and techniques of
statistical inferences with actual measurements. 3
WHY ECONOMETRICS AS DISTINCT DISCIPLINE

 For the forgoing definitions we learn that econometrics is an amalgam

of economic theory, mathematical economics, economic statistics and
mathematical statistics.
 Yet the subject deserves to be studied in its own right for the following
reasons.
 Economic theory makes statement or hypotheses that are mostly
qualitative in nature, law of demand
 Mathematical economics expresses economic theory in terms of
mathematical techniques, symbols (equation) without regard to
measurability or empirical verification of the theory.
 Economic statistics is mainly concerned with collecting,
processing and presenting economic data in the form of charts and
table. It is an application of descriptive statistics on economic
theory.
 Mathematical statistics is mainly concentrated with statistical
inference.
 But econometrics is mainly interested in empirical verification of 4
the theory.
CONT’D
In Econometrics we start with relationship derived
from economic theory, express them in mathematical
terms and measure them using econometric methods
to obtain numerical estimate of the coefficient in
economic model or relationships.
 Economic theory: qualitative results, e.g.
Demand Curves Slope Downward
 Economic model/Mathematical model: quantitative
results, e.g.
 price elasticity of demand for milk = -0.75
 Statistics: “summarize the data faithfully”;
“let the data speak for themselves.”
 Econometrics: “ what do we learn from economic
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theory AND the data at hand?”
EXAMPLES OF THE KIND OF PROBLEMS THAT MAY BE SOLVED
BY AN ECONOMETRICIAN

 Testing whether financial markets are weak-form informationally

efficient.
 Testing whether the CAPM or APT represent superior models for the
determination of returns on risky assets.
 NB: Capital Asset pricing Model (CAPM) models the relationship
between systematic risk and expected return for assets and APT
(Arbitrage pricing theory) is a general theory of asset pricing. It models
return on asset as a function of many factors.
 Measuring and forecasting the volatility of bond returns.
 Explaining the determinants of bond credit ratings used by the ratings
agencies.
 Modelling long-term relationships between prices and exchange rates.
 Determining the optimal hedge ratio for a spot position in oil.
 Testing technical trading rules to determine which makes the most money.
 Testing the hypothesis that earnings or dividend announcements have no
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effect on stock prices.
 Testing whether spot or futures markets react more rapidly to news.
 Forecasting the correlation between the returns to the stock indices of two
 1.2 Models: Economic models vs Econometric models
 What is a model?
 A model is a simplified representation of real world
process. For instance, saying that the quantity demanded
of oranges depends on the price of oranges is a simplified
representation because there are a host of other variables
that one can think of that determine the demand for
oranges (e.g. income, price of related goods, consumer
preferences etc.).
 Merits
 Helps to move from simple to complex
 Easily communicated
 Easily understood
 Easily tested empirically
 Demerits
 Unrealistic assumptions
 Over simplification
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CONT’D
 An Economic model is a set of assumptions that
approximately describes the behavior of an economy
or sector of an economy
 An Econometric model consists of the following:
1. A set of behavioral equation derived from the economic
model. This equations involve some observed variables and
some “disturbance” (which are a catchall for all the
variables considered as irrelevant for the purpose of this
model as well as all unforeseen events).
2. A statement of whether there are errors of observation in
the observed variables.
3. A specification of the probability distribution of the
“disturbances” (and errors of measurement).
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 q o     P o Economic model
q o     P o  u Econometric model

 Disturbance/error term includes: irrelevant variables;

errors of measurement; excluded variables by mistake
and unforeseen conditions

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1.3 METHODOLOGY OF ECONOMETRICS

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STEPS INVOLVED IN THE FORMULATION OF ECONOMETRIC MODELS

Economic or Financial Theory (Previous Studies)

Formulation of an Estimable Theoretical Model

Collection of Data

Model Estimation

Is the Model Statistically Adequate?

No Yes

Reformulate Model Interpret Model

Use for Analysis

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 ANATOMY OF ECONOMETRIC MODELING: TRADITIONAL
APPROACH

1. Statement of theory or hypothesis

2. Specification of the mathematical model of the
theory
3. Specification of statistical or econometric model
4. Obtaining the data
5. Estimation of the parameters of the econometrics
model
6. Hypothesis testing
7. Forecasting or prediction
8. Using the model for control or policy purpose

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 ILLUSTRATION
 To illustrate the above let us use Keynesian theory of
consumption.
 Statement of theory/ hypothesis

1. As income increase consumption expenditure

increases but less than the increment in income, i.e.,
0< mpc < 1
2. Specification of the mathematical model of the theory,
Y     X , 0< <1
1 2
2
Where Y=consumption expenditure, X income and 1 &
2 are unknown parameters

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CONT’D
3. Specification of statistical or econometric model
Y    X u
1 2

4. Obtaining the data: to estimate the above

econometric model, i.e., to obtain numerical data of  1

and  , we need data.

2

5. Estimation: estimation of the parameters using

regression analysis, 14
CONT’D
6. Hypothesis testing: Does the MPC satisfies the
positive and less than unit hypothesis? We use
statistical inference.
7. Forecasting or prediction: if the hypothesis is true
use the estimated coefficients to predict the future
value(s) of the dependent variable for a given value of
the independent variable. Example if income in 2021
is 1000 what will be consumption exp.?
Y2021= -184.08 + 0.7064(1000) = 522.32

8. Using the model for control or policy purpose: what

level of income will keep consumption expenditure to
some desired level? 15
1.4 THE SOURCES, TYPES AND NATURE OF ECONOMETRIC DATA

 Data Sources
 Primary: first-hand information….collected by the
person under consideration using different
instruments.
 Secondary: from ancillary sources
 We can generated secondary data from:
 Government organizations (e.g. MOFEC, Inland Revenue
Authority, CSA, NBE)
 International Organization (e.g. IMF, WB,OECD,WDI,
Penny table etc.)
 Private institutions, Financial institution
 Internet
 Personally generated primary data

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TYPES OF DATA
 Cross-sectional
 Time series
 Pooled cross-section and
 Panel data.
 A cross-sectional data set consists of a sample of
individuals, households, firms, cities, states, countries,
or a variety of other units, taken at a given point in time
e.g.
 Households income and consumption expenditure for a given time
 Cross-section of farm households technology adoption in Ethiopia for
the year 2016
 Examples of Problems that Could be Tackled Using a Cross-
Sectional Regression
 The relationship between company size and the return to investing in its
shares
 The relationship between a country’s GDP level and the probability that
the government will default on its sovereign debt.
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TIME SERIES DATA
 Consists of observations on a variable or several
variables over time.
 Examples of time series data include stock prices,
money supply, consumer price index, gross domestic
product, annual homicide rates, and automobile sales
figures.
 Examples of Problems that Could be Tackled Using a Time
Series Regression
 How the value of a country’s stock index has varied with that
country’s macroeconomic fundamentals.
 Effect of FDI on countries GDP.
 The effect on a country’s currency of an increase in its interest rate

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 TIME SERIES DATA

 The data may be quantitative (e.g. income, age, prices, expenditure), or

qualitative (e.g. day of the week, type of business, sex of owner).

 Examples of time series data

Data Frequency
GNP or unemployment monthly, or quarterly
government budget deficit annually
money supply weekly
value of a stock market index as transactions occur

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 POOLED CROSS SECTIONS

 Some data sets have both cross-sectional and time

series features.
 For example, suppose that two cross-sectional
household surveys are taken in Ethiopia, one in 2010
and one in 2015.
 In 2010, a random sample of households is surveyed for
variables such as income, savings, family size, and so on.
 In 2015, a new random sample of households is taken using
the same survey questions.
 In order to increase our sample size, we can form a pooled
cross section by combining the two years (e.g. HICE of
Ethiopia).
 Used to analysis effectiveness of government policy.
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PANEL DATA
 A panel data set consists of a time series for each
cross-sectional member in the data set.
 As an example, suppose we have wage, education,
and employment history for a set of individuals
followed over a ten-year period.
 It could be collecting information, such as investment
and financial data, about the same set of firms over a
five-year time period.
 Panel data can also be collected on geographical units.
For example, we can collect data for the same set of
regions in Ethiopia on immigration flows, tax rates,
wage rates, government expenditures, etc., for the
years 2000, 2005, and 2010.
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CONTINUOUS AND DISCRETE DATA

 Continuous data can take on any value and are not confined to take
specific numbers.

 Their values are limited only by precision.

 For example, the rental yield on a property could be 6.2%, 6.24%, or 6.238%.

 On the other hand, discrete data can only take on certain values, which are
usually integers
 For instance, the number of people in a particular city or the number of cars
sold during a day.

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CARDINAL, ORDINAL AND NOMINAL NUMBERS
 Another way in which we could classify numbers is according to whether
they are cardinal, ordinal, or nominal.
 Cardinal numbers are those where the actual numerical values that a
particular variable takes have meaning, and where there is an equal
distance between the numerical values.
 Examples of cardinal numbers would be the price of a share or of a building,
and the number of houses in a street.
 Ordinal numbers can only be interpreted as providing a position or an
ordering.
 Thus, for cardinal numbers, a figure of 12 implies a measure that is `twice as
good' as a figure of 6. On the other hand, for an ordinal scale, a figure of 12
may be viewed as `better' than a figure of 6, but could not be considered
twice as good.
 Examples of ordinal numbers would be the position of a runner in a race.

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CARDINAL, ORDINAL AND NOMINAL NUMBERS

 Nominal numbers occur where there is no natural ordering of the values at

all.
 Such data often arise when numerical values are arbitrarily assigned, such as
telephone numbers or when coding are assigned to qualitative data (e.g. when
describing perception of individual).

 Cardinal, ordinal and nominal variables may require different modeling

approaches or at least different treatments, as should become evident in the
subsequent chapters.

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