Classical Linear Regression Model

Introduction

1
 Introduction:
The Nature and Purpose of Econometrics

• What is Econometrics?

• Literal meaning is “measurement in economics”.

• Definition of financial econometrics:

The application of statistical and mathematical techniques to problems in
finance.
 Examples of the kind of problems that
may be solved by an Econometrician

1. Testing whether financial markets are weak-form informationally

efficient.

2. Testing whether the CAPM or APT represent superior models for the
determination of returns on risky assets.

3. Measuring and forecasting the volatility of bond returns.

4. Explaining the determinants of bond credit ratings used by the ratings

agencies.

5. Modelling long-term relationships between prices and exchange rates

 Examples of the kind of problems that
may be solved by an Econometrician (cont’d)

6. Determining the optimal hedge ratio for a spot position in oil.

7. Testing technical trading rules to determine which makes the most

money.

8. Testing the hypothesis that earnings or dividend announcements have

no effect on stock prices.

9. Testing whether spot or futures markets react more rapidly to news.

10.Forecasting the correlation between the returns to the stock indices of

two countries.
 What are the Special Characteristics
of Financial Data?

• Frequency & quantity of data

Stock market prices are measured every time there is a trade or somebody
posts a new quote.

• Quality
Recorded asset prices are usually those at which the transaction took
place. No possibility for measurement error but financial data are “noisy”.
 Types of Data and Notation

• There are 3 types of data which econometricians might use for analysis:
1. Time series data
2. Cross-sectional data
3. Panel data, a combination of 1. & 2.

• The data may be quantitative (e.g. exchange rates, stock prices, number of
shares outstanding), or qualitative (e.g. day of the week).

• Examples of time series data

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

• 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.
- How the value of a company’s stock price has varied when it announced the
value of its dividend payment.
- The effect on a country’s currency of an increase in its interest rate

• Cross-sectional data are data on one or more variables collected at a single

point in time, e.g.
- A poll of usage of internet stock broking services
- Cross-section of stock returns on the NSE
- A sample of bond credit ratings for Kenyan banks
 Cross-sectional and Panel Data

• 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.

• Panel Data has the dimensions of both time series and cross-sections, e.g. the
daily prices of a number of blue chip stocks over two years.

• It is common to denote each observation by the letter t and the total number of
observations by T for time series data, and to denote each observation by the
letter i and the total number of observations by N for cross-sectional data.
 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 underground carriage or the number
of shares traded during a day.

• They do not necessarily have to be integers (whole numbers) though, and are
often defined to be count numbers.
– For example, until recently when they became ‘decimalised’, many financial asset
prices were quoted to the nearest 1/16 or 1/32 of a dollar.
 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.
 Cardinal, Ordinal and Nominal Numbers (Cont’d)

• 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 codings are assigned to qualitative data (e.g. when describing the
exchange that a NSE stock is traded on.

• Cardinal, ordinal and nominal variables may require different modelling

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

• It is preferable not to work directly with asset prices, so we usually convert the raw
prices into a series of returns. There are two ways to do this:
Simple returns or log returns

p  pt 1  p 
Rt  t 100% Rt  ln t   100%
pt 1  pt 1 
where, Rt denotes the return at time t
pt denotes the asset price at time t
ln denotes the natural logarithm

• We also ignore any dividend payments, or alternatively assume that the price series
have been already adjusted to account for them.
 Log Returns

The returns are also known as log price relatives, which will be used throughout this
book. There are a number of reasons for this:
1. They have the nice property that they can be interpreted as continuously
compounded returns.
2. Can add them up, e.g. if we want a weekly return and we have calculated
daily log returns:
r1 = ln p1/p0 = ln p1 - ln p0
r2 = ln p2/p1 = ln p2 - ln p1
r3 = ln p3/p2 = ln p3 - ln p2
r4 = ln p4/p3 = ln p4 - ln p3
r5 = ln p5/p4 = ln p5 - ln p4

ln p5 - ln p0 = ln p5/p0
 A Disadvantage of using Log Returns

• There is a disadvantage of using the log-returns. The simple return on

a portfolio of assets is a weighted average of the simple returns on the
individual assets:
N
R pt   wip Rit
i 1

• But this does not work for the continuously compounded returns.
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

 Some Points to Consider when reading papers
in the academic finance literature

1. Does the paper involve the development of a theoretical model or is it

merely a technique looking for an application, or an exercise in data
mining?

2. Is the data of “good quality”? Is it from a reliable source? Is the size of

the sample sufficiently large for asymptotic theory to be invoked?

3. Have the techniques been validly applied? Have diagnostic tests for
violations of been conducted for any assumptions made in the
estimation
of the model?
 Some Points to Consider when reading papers
in the academic finance literature (cont’d)

4. Have the results been interpreted sensibly? Is the strength of the results
exaggerated? Do the results actually address the questions posed by the
authors?

5. Are the conclusions drawn appropriate given the results, or has the
importance of the results of the paper been overstated?
Additional Notes and
Examples
Cross-Sectional
 Cross-Sectional Data

HHID Age Sex Income Residence

1 34 Male 100000 Kiambu
2 23 Female 5000 Kisumu
3 42 Female 6000 Mombasa
4 56 Male 600000 Nairobi
5 45 . 70000 Kiambu
6 67 Male . Nakuru
7 54 Female 600000 Kiambu
8 33 Male 70000 Nairobi
9 43 . 80000 Kiambu
Time Series Data
Time Series Data
Application of Time Series
Longitudinal/Panel Data
Panel/Longitudinal Data
Big-Data Analysis
Big-Data Analysis
Big-data Analysis
Applications of Big Data Analytics
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Chapter Two