Department of Accounting and

Finance
Econometrics for Finance
(AcFn3112)

Addis Ababa, Ethiopia

March 2022

Econometrics for Finance

By Asimamaw B.
Econometrics for Finance
Course teacher: Demilie B.
Email: [email protected]

Course Objective:
✓ Understand the econometric models
✓ Type of variables (dependent vs independent(explanatory), continuous vs
categorical)
✓ Understand type of data
✓ Do simple and multiple regression with economic data ( in business area)
✓ Interpret regression results (like coefficients and R_squared) and test
hypotheses (both manually and using statistical packages); and
✓ Detect (in) existence of problems of multicollinearity, heteroscedasticity and
autocorrelation as well as suggest how to rectify such problems.
Econometrics for Finance
By Asimamaw B.
Course Contents:
 Chapter 1: The subject matter of Econometrics
 Chapter 2: Simple Linear Regression (LS)
 Chapter 3: Multiple Linear Regression Analysis
 Chapter 4: Violations of the Assumptions of Classical Model
 Chapter 5: Multiple Regression Analysis with Qualitative
Information: Binary (or Dummy Variables)
 Chapter 6: Basic Regression Analysis with Time Series Data:
Basic Concepts
 Chapter 7: Introduction to simultaneous equation models/Panel
Data (Optional)

Econometrics for Finance

By Asimamaw B.
Assessment

Econometrics for Finance

By Asimamaw B.
References
• Frank J. Fabozzi (2014). The Basics of Financial Econometrics:
Tools, Concepts, and Asset Management Applications. John Wiley
& Sons, Inc., Hoboken, New Jersey.
• Chris Brooks (2008). Introductory Econometrics for Finance (2nd
Edition). Cambridge University Press.
• Gujarati, D. N. and D. C. Proter (2009). Basic Econometrics,
5thedition,McGraw-Hill
• Wooldridge, J. (2013). Introductory Econometrics: A Modern
Approach, 5thEd.
• James H. Stock & Mark W. Watson (2015). Introduction to
Econometrics (Third edition). Pearson Education, Inc.

Econometrics for Finance

By Asimamaw B.
 1.1. What Is Econometrics?
▪ In the present world, research in economics, finance,
management, marketing, and related disciplines is
becoming increasingly quantitative.

▪ Econometrics means economic measurement or

measurement of economic data.
▪ It is an integration of economics, mathematical
economics and statistics with an objective to provide
numerical values to the parameters of economic
relationships.

Econometrics for Finance

By Asimamaw B.
▪ Definition of financial econometrics:
✓ The application of statistical and mathematical
techniques to problems in finance.
✓ Financial econometrics is the science of modeling
and forecasting financial data.
▪ The econometric tools are helpful in explaining the
relationships among variables.

▪ Econometrics is concerned with summarizing relevant

data information by means of a model.
▪ Such econometric models help to understand the relation
between economic and business variables and to analyze
the possible effects of decisions.
Econometrics for Finance
By Asimamaw B.
 Econometrics vs. mathematical economics
▪ Mathematical economics formulates or express economic
theory in mathematical terms or form and uses the methods
of mathematics to derive economic relationships from
certain basic assumptions or axioms.
▪ It formulates equations or models to analyze economic
relationships between the data with the background from
economic theory.

Econometrics for Finance

By Asimamaw B.
▪ Mathematical economics do not allows for random
elements which might affect the relationship and make it
stochastic.
▪ It does not provide numerical values for the
coefficients of economic relationships.
▪ Econometric methods are designed to take into account
random disturbances.
▪ It provide numerical values of the coefficients of
economic relationships.

Econometrics for Finance

By Asimamaw B.
 Econometrics and statistics
▪ In economic statistics, the empirical data is collected
recorded, tabulated and used in describing the pattern
in their development over time.
✓ The economic statistics is a descriptive aspect of
economics.
✓ It does not provide either the explanations of the
development of various variables or measurement
of the parameters of the relationships

Econometrics for Finance

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 Economic Mathematical
Theory Economics
provides theory or expresses economic
imposes a logical theory using
structure on the mathematical form
question

Econometrics

Providing Estimation
data presentation and testing techniques
and description
Economic Mathematic
Statistics Statistics
Econometrics for Finance
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 1.2 Models
 A model is the simplified representation
of actual/real phenomena.
 Modelling is an integral part of most
scientific inquiry.
 A model is a compromise between reality
and manageability.

Econometrics for Finance

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Economic vs. econometric models
 Economic models: Any economic theory
is an observation from the real world. A
deliberately simplified analytical framework
is called an economic model.
 Economic models consist of the following
three basic structural elements.
◦ A set of variables
◦ A list of fundamental relationships and
◦ A number of strategic coefficients

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Example
 Model of job training and worker productivity
◦ What is effect of additional training on worker productivity?
◦ Formal economic theory not really needed to derive equation:

Hourly wage

Years of formal
education Weeks spent
Years of work- in job training
force experience
◦ Other factors may be relevant, but these are the most important (?)

Econometrics for Finance

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 Econometric models: contain a random
element.
◦ Mathematical economic models

◦ Econometric model would be of the stochastic

form:

 where u stands for the random factors which affect

the quantity demanded.

▪ An econometric model will either be linear or non-linear

in parameters and variables.
▪ Econometric models can be either static or dynamic
Econometrics for Finance
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 Example
 Econometric model of job training and worker productivity

Unobserved deter-
minants of the wage

e.g. innate ability,

Hourly wage Years of formal Years of work- Weeks spent quality of education,
education force experience in job training family background …

 Most of econometrics deals with the specification of the error

 Econometric models may be used for hypothesis testing

◦ For example, the parameter represents effect of training on wage

◦ How large is this effect? Is it different from zero?

Econometrics for Finance
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1.3. Methodology of Econometrics
 The traditional/classical econometric
methodology includes:
(1) Statement of theory or hypothesis:
Keynes stated: ”Consumption increases as income
increases, but not as much as the increase in
income”. It means that “The marginal propensity to
consume (MPC) for a unit change in income is
grater than zero but less than unit”

Econometrics for Finance

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(2) Specification of the mathematical
model of the theory
Y = ß1+ ß2X ; 0 < ß2< 1
Y= consumption expenditure and X= income
ß1 and ß2 are parameters; ß1 is intercept, and ß2 is slope
coefficients
(3) Specification of the econometric
model of the theory
◦ The relationships between economic variables are
generally inexact. In addition to income, other
variables affect consumption expenditure. For
example, size of family, ages of the members in the
family, family religion, etc., are likely to exert some
influence on consumption.
Econometrics for Finance
By Asimamaw B.
 To allow for the inexact relationships between
economic variables, the mathematical
equation is modified as follows:
Y = ß1+ ß2X + u ; 0 < ß2< 1;
u is disturbance term or error term. It is a random
or stochastic variable.

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Example
 A deterministic relationship
P Qd
25 1
20 3
15 5
10 7
5 9
0 11

 A random relationship
f( ) P Qd E(Qd)
25 2 or1or 0 1
1 0.25
20 4 or 3or 2 3
0 0.5 15 6 or 5 or 4 5
-1 0.25 10 8 or 7 or 6 7
5 10 or 9 or 8 9
0 12 or 11or 10 11

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(4) Obtaining Data
 An econometric model requires data on
all the variables in the model.
Year X Y

1980 2447.1 3776.3

1981 2476.9 3843.1
1982 2503.7 3760.3
1983 2619.4 3906.6
1984 2746.1 4148.5
1985 2865.8 4279.8
1986 2969.1 4404.5
1987 3052.2 4539.9
1988 3162.4 4718.6
1989 3223.3 4838.0
1990 3260.4 4877.5
1991 3240.8 4821.0

(5) Estimating the Econometric Model

Y^ = - 231.8 + 0.7194 X
MPC was about 0.72
Note: A hat symbol (^) above one variable will signify
an estimator of the relevant population value
Econometrics for Finance
By Asimamaw B.
(6) Hypothesis Testing
 Are the estimates accord with the
expectations of the theory that is being
tested? Is MPC < 1 statistically?
(7) Forecasting or Prediction
 With given future value(s) of X, what is the
future value(s) of Y?
 Example: if GDP=$6000Bill in 1994, what is
the forecast consumption expenditure?
Y^= - 231.8+0.7196(6000) = 4084.6

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(8) Using model for control or
policy purposes

Y=4000= -231.8+0.7194 X  X  5882

 MPC = 0.72, an income of $5882 Bill will

produce an expenditure of $4000 Bill. By fiscal
and monetary policy, Government can
manipulate the control variable X to get the
desired level of target variable Y

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The purpose of econometrics
 The principal purposes of econometrics
are:
◦ structural analysis,
◦ forecasting and
◦ policy evaluation.

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 1.4.Types of Data for Econometrics
Analysis
 Data based on sources is classified in to
primary and secondary.
✓ Primary data: these are the data collected from the
sample respondents directly through informal
discussions.
o The researcher himself collects the data from the
(sample) respondents informally, he gets the precise
data actually needed for the research project.
✓Secondary data: These are the data and requisite
information collected from authentic published sources.
o Data collected from those, which have already
been collected and analyzed by someone else
Econometrics for Finance
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 Data types can also be classified as:
→Non experimental Vs experimental data

 Non-experimental data are obtained from observations of

a system that is not subject to experimental control, while
experimental data are obtained from controlled
experiments in laboratory.

Econometrics for Finance

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→Qualitative versus quantitative data
 Data, as a matter of definition, is
quantitative. Thus facts, which are already
expressed as numbers.
 When the variables are qualitative in nature, then the
data is recorded in the form of the indicator function.

✓The values of the variables do not reflect the magnitude

of the data.

✓They reflect only the presence/absence of a

characteristic.
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✓ For example, variables like religion, sex, taste, etc. are
qualitative variables.
✓ The variable `sex’ takes two values – male or female,
the variable `taste’ takes values-like or dislike etc.
✓ Such values are denoted by the dummy variable.
✓ For example, these values can be represented as ‘1’
represents male and ‘0’ represents female.

Econometrics for Finance

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→Time series versus cross section data
◦ Cross-section data
◦ Time-series data
◦ Pooled cross-sections
◦ A panel data (or longitudinal data) set
 Econometric methods depend on the
nature of the data used
◦ Use of inappropriate methods may lead to
misleading results

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 Cross-sectional data sets
◦ Sample of individuals, households, firms, cities, states,
countries, or other units of interest at a given point of
time/in a given period
◦ Cross-sectional observations are more or less
independent
◦ For example, pure random sampling from a population
◦ Sometimes pure random sampling is violated, e.g. units
refuse to respond in surveys, or if sampling is
characterized by clustering
◦ Cross-sectional data typically encountered in applied
microeconomics
Econometrics for Finance
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Cross-sectional data sets

Econometrics for Finance

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Cross-sectional data sets
 Time series data
◦ Observations of a variable or several variables over time
◦ For example, stock prices, money supply, consumer price
index, gross domestic product, annual homicide rates,
automobile sales, …
◦ Time series observations are typically serially
correlated
◦ Ordering of observations conveys important information
◦ Data frequency: daily, weekly, monthly, quarterly,
annually, …
◦ Typical features of time series: trends and seasonality
◦ Typical applications: applied macroeconomics and
finance
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  Time series data on minimum wages and related
variables

Average minimum Average Unemployment Gross national

wage for given year coverage rate rate product

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 Pooled cross sections
◦ Two or more cross sections are combined in one data
set
◦ Cross sections are drawn independently of each other
◦ Pooled cross sections often used to evaluate policy
changes
◦ Example:
 Evaluate effect of change in property taxes on house
prices
 Random sample of house prices for the year 1993
 A new random sample of house prices for the year
1995
 Compare before/after (1993: before reform, 1995: after
reform) Econometrics for Finance
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 Pooled cross sections on housing prices

Property tax
Size of house
in square feet

Number of bathrooms

Before reform

After reform

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 Panel or longitudinal data
◦ The same cross-sectional units are followed over time
◦ Panel data have a cross-sectional and a time series
dimension
◦ Panel data can be used to account for time-invariant
unobservables
◦ Panel data can be used to model lagged responses
◦ Example:
 City crime statistics; each city is observed in two years
 Time-invariant unobserved city characteristics may be
modeled
 Effect of police on crime rates may exhibit time lag

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 Two-year panel data on city crime
statistics

Each city has two time

series observations

Number of
police in 1986

Number of
police in 1990

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38
 Univariate data, Bivariate data and
Multivariate data
 Univariate, bivariate and multivariate data are the
various types of data that are based on the number of
variables considered in the research study.
 Univariate data: This data explains the variation about
a single variable.
✓ For example, if the researcher wishes to study the age distribution
of farmers in a village and graph the data, it implies there is only
one variable ie., ‘the age of the farmers’.
✓ it does not deal with relationships, but rather it is used to describe
something.
Econometrics for Finance
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▪ Bivariate data: Bivariate data are data that involves two
different variables, whose values can change.
✓ The purpose of bivariate data is to analyze and explain
the relationship between the two variables.
✓ For example: quantity demanded and price of the
commodity.
▪ Multivariate data: Multivariate data are data in which
analysis is based on more than two variables per
observation.
✓ For example: fertilizers costs, irrigation costs, pesticides
costs, weeding costs etc., incurred on wheat crop
influence the output of wheat.

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▪ This is given by: Dependent variable = function of
(independent variables).
▪ In case of univariate data, there is only independent
variable ie.,
Y = a + bX. (For example, price of a commodity is
influenced by the market arrivals).
✓ In case of bivariate data, there are two independent
variables ie., Y = a + b1X1 + b2X2.
✓ For example, output of crop is influenced by both
land area and fertilizer dosage on that crop). tc.

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▪ In case of multi-variate data, there are more than two
independent variables ie.,
Y = a + b1X1 + b2X2 + b3X3 + b4X4.
✓ For example, gross returns of paddy is influenced by
several costs like fertilizers costs, irrigation costs,
pesticides costs, weeding costs, human labour costs,
machinery labour costs, manure costs , etc.

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▪ Micro data and Macro data: The data may be collected at
various levels of aggregation and accordingly:
✓ Micro-data: These data are collected on individual
economic decision making units such as individuals,
households or firms.
✓ Macro-data: These data result from a pooling or
aggregating over individuals, households or firms at the
local, state or national levels.
The End of Chapter One”
Thank you for your attention!

Econometrics for Finance

By Asimamaw B.