Econometrics for Finance

Academic Year: 2017 E.C

Compiled by: Tesfaye A
 Chapter One: Introduction
• 1.1. Definition and scopes of Econometrics
• Literally: composition of : “economics” and
“measurement”
• “. . . econometrics may be defined as the
quantitative analysis of actual economic
phenomena based on the concurrent
development of theory and observation, related
by appropriate methods of inference.”
(Samuelson, Koopmans, & Stone)
 Con’d

• “. . . econometrics may be considered as the

integration of economics, mathematics and
statistics for the purpose of providing
numerical values for the parameters of
economic relationships. . . ” (Koutsoyiannis)
• Econometrics is the science and art of using
economic theory and statistical techniques to
analyze economic data (Stock and Watson).
 Con’d

• Why a separate discipline?

• economics vs. econometrics
• economics: focus on “how” and “why”
• econometrics: focus on “how much” and “by how much”

• example:
– economist: “If the government increases alcohol excise tax,
consumers will cut down on their alcohol consumption.”
– econometrician: “If the government increases alcohol excise tax by
20%, consumers will reduce their alcohol consumption by 1%.”
 Con’d

• econometrics is not concerned with the

numbers themselves (the concrete information
in the previous example), but rather with the
methods used to obtain the information
→crucial role of statistics
 Co..

In other words,
• Economic theory makes statements that
are mostly qualitative in nature, while
econometrics gives empirical content to most
economic theory
• Mathematical economics is to express
economic theory in mathematical form
without empirical verification of the theory,
while econometrics is mainly interested in
the later.
 Co…

• Economic Statistics is mainly concerned

with collecting, processing and presenting
economic data. It does not being concerned
with using the collected data to test
economic theories.
• Mathematical statistics provides many of
tools for economic studies, but econometrics
supplies the later with many special methods
of quantitative analysis based on economic
data.
 Methodology of Econometrics

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”
 (2) Specification of the
mathematical model of the theory
Y = ß1+ ß2X ; 0 < ß2< 1
Y= consumption expenditure
X= income
ß1 and ß2 are parameters; ß1 is
intercept, and ß2 is slope coefficients
 Co..

(3) Specification of the econometric

model of the theory
Y = ß1+ ß2X + u ; 0 < ß2< 1;
Y = consumption expenditure;
X = income;
ß1 and ß2 are parameters; ß1is intercept and ß2
is slope coefficients; u is disturbance term or
error term. It is a random or stochastic variable
 Co...

(4) Obtaining Data

Y= Personal consumption
expenditure
X= Gross Domestic Product
all in Billion Ethiopian birr
 Co...
(4) Obtaining Data
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
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(5) Estimating the Econometric Model

Y^ = - 231.8 + 0.7194 X
MPC was about 0.72 and it means that for
the sample period when real income
increases 1 birr, led (on average) real
consumption expenditure increases of
about 72 cents

Note: A hat symbol (^) above one variable

will signify an estimator of the relevant
population value
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(6) Hypothesis Testing
Are the estimates accord with the
expectations of the theory that is being
tested?
• Is MPC < 1 statistically?
• If so, it may support Keynes’ theory.
• Confirmation or refutation of economic
theories based on sample evidence is
object of Statistical Inference (hypothesis
testing).
 Co..
(7) Forecasting or Prediction
 With given future value(s) of X, what is the
future value(s) of Y?
 GDP=6000Bill birr in 2014 E.C, what is the
forecast consumption expenditure?
 Y^= - 231.8+0.7196(6000) = 4084.6
 Income Multiplier M = 1/(1 – MPC) (=3.57).
decrease (increase) of 1 birr in investment will
eventually lead to 3.57 birr decrease (increase)
in income.
 Co..

(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 birr
will produce an expenditure of 4000 Bill
birr.
• By fiscal and monetary policy,
government can manipulate the control
variable X to get the desired level of
target variable Y
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 (capital asset pricing model)

or APT (Arbitrage pricing theory) 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
 Co..

6.Testing technical trading rules to

determine which makes the most money.
7.Testing the hypothesis that earnings or
dividend announcements have no effect
on stock prices.
8.Testing whether spot or futures markets
react more rapidly to news.
9. Forecasting the correlation between the
returns to the stock indices of two
countries.
 Sources, Types and nature of Data
• In econometrics there are three main types of data
(not necessarily mutually exclusive)
– Cross-sectional data
– Time series data
– Panel (longitudinal) data
• All these different data types require specific
econometric and statistical techniques for data
analysis and
• The data may be quantitative (e.g. Exchange rates,
stock prices, number of shares outstanding), or
qualitative (e.g. day of the week).
 Co..

• Cross-Section
– A type of one-dimensional data set
– Collected by observing many subjects (such as
individuals, firms or countries/regions) at the
same point of time, or without regarding the
differences in time
– In general used to compare the differences among
the subjects
– Order does not matter
• Examples: Explaining people's wages by reference to
their education level
• 24
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• Time Series
– A sequence of data points, measured typically at
successive times spaced at uniform time intervals i.e.,
annual, semi-annual, quarterly, monthly, daily and so
on.
– Time series models often make use of the natural one-
way ordering of time so that values for a given period
will be expressed as deriving in some way from past
values, rather than from future values
– Have a natural temporal ordering
– Examples: Annual ination rates, daily closing value of a
certain stock
Co..
 co..

• 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
 Co..

• Panel (Longitudinal)
– Date that involve repeated observations of the
same items over long periods of time
– Not necessarily cohort study Different cohorts
may have different subjects
– Panel data (Longitudinal) studies track the same
subject (people, countries, same set of stocks)
– Measurements are observed or taken on the same
subjects repeatedly.
Co…
 Sources of data
• There are two types of sources of data.
– Primary
– Secondary
• Primary: First hand, raw, or original materials that researchers
study and analyze.
• Involves consulting historical documents, visuals, journals and
letters, autobiographies, memoirs, government statistics and
studies, and speeches.
• Involves examining works of art, literature, and architecture or
watch or listen to performances and programs.
• Involves study or initiating case studies or scientific
experiments and take extensive field notes.
• Conduct interviews and use data collected from
questionnaires.
 Co…

• Secondary Sources
• Analytical works that comment on and
interpret other works, such as primary
sources.
• Examples include reviews, discussions,
biographies, critical studies, analysis of literary
or artistic works or event, commentaries on
current and historical events, class lectures,
and electronic discussions.
 Nature of data

• As shown in the following figure, we can

see Data in two distinct
ways: Categorical and Numerical:
 Co…
• Categorical data are values or observations
that can be sorted into groups or categories.
• There are two types of categorical values,
nominal and ordinal.
• A nominal variable has no intrinsic ordering to
its categories.
– For example, housing is a categorical variable
having two categories (own and rent).
• An ordinal variable has an established
ordering.
– For example, age as a variable with three orderly
categories (young, adult, and elder).
 Co…
• Numerical data are values or observations that can
be measured.
• There are two kinds of numerical values, discrete
and continuous.
• Discrete data are values or observations that can be
counted and are distinct and separate.
– For example, number of lines in a code.
• Continuous data are values or observations that
may take on any value within a finite or infinite
interval.
– For example, an economic time series such as historic
gold prices.