Empirical Methods For Finance: Sjoerd Van Den Hauwe
Empirical Methods For Finance: Sjoerd Van Den Hauwe
(FEM11198-21)
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Motivation
Remedies
I Summarizing the regressors in fewer variables (dimension reduction).
I Combining proxies to extract a stronger signal of the financial quantity.
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Setting
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Regressor Combination
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Principal Components
Hence, the sample variance of the first principal component z1 is larger than
the second’s, z2 ’s, etc.
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Investor Sentiment Example
Proxies can be
I Survey based (e.g., confidence indexes)
I Market based (trading characteristics)
Both can be dealt with using PCA to extract a common component that is
defined as investor sentiment.
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Market-Based Proxies
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Transformations
→ Check plots.
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Example
Timing:
Some proxies lead/lag (inspecting plots and cross-correlations):
I Dividend premium (PDND) leads 12 months.
I RIPO leads 12 months.
Transformations:
I 12-Month moving averages to remove noise.
I All 5 proxies standardized.
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Inversely Related Proxies
2 Transformed proxies inversely related to sentiment, Jan. 1967–Dec. 2018
-1
-2
-3
70 75 80 85 90 95 00 05 10 15
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Positively Related Proxies
3 Transformed proxies positively related to sentiment, Jan. 1967–Dec. 2018
-1
-2
70 75 80 85 90 95 00 05 10 15
RECESSION RIPO
NIPO ENI
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Eigenvalues and Eigenvectors
Aei = λi ei
Note:
I Eigenvectors are known up to a proportionality factor.
I If ei is an eigenvector, then c · ei is.
I We normalize the eigenvectors (=have unit length) such that ei 0 ei = 1.
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Computing Principal Components
Employing PCA:
1. Compute all eigenvalue-eigenvector pairs (λk , ek ) of R, (k = 1, 2, . . . , J) .
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Correlation Matrix
Correlation matrix:
CEFD NIPO PDND RIPO ENI
CEFD 1
NIPO −0.35 1
R=
PDND 0.61 −0.53 1
RIPO −0.24 0.29 −0.51 1
ENI 0.25 0.27 −0.04 0.15 1
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Loadings
−0.473 0.467 0.208
0.482
0.256
−0.540
e1 =
−0.589 ,
e2 =
0.081 ,
e3 =
−0.028 ,
0.437 0.182 0.805
0.080 0.822 −0.126
0.489 −0.525
0.621
0.159
e4 =
0.200 ,
e5 =
0.778 .
0.213 0.287
−0.538 0.109
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Interpretation
Check how the kth SPC zk loads on the original variables xj , (j = 1, . . . , J).
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Investor Sentiment Index
Time-series plot Baker & Wurgler Investor Sentiment, Jan. 1967–Dec. 2018.
-1
-2
-3
-4
70 75 80 85 90 95 00 05 10 15
RECESSION
PC1 -- Investor Sentiment
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Number of Components
Pp
As SPCs are uncorrelated, the first p explain J −1 k=1 λk × 100%.
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Choosing Components
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Scree Plot
Cumulative percentage of total sample variance explained by kth SPC
kth SPC
1 2 3 4 5
% 46 71 86 94 100
2.4
2.0
1.6
1.2
0.8
0.4
0.0
1 2 3 4 5
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Principal Components Regression
Observations zk,i on the first p SPCs can serve as regressors in a model for yi ,
p
X
yi = β0 + βk zk,i + εi .
k=1
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Course Conclusions
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Last Words . . .
This course epitomized in the ”Last Words” by Angrist & Pischke (2009,
p.327):
”If applied econometrics were easy, theorists would do it. But it’s
not as hard as the dense pages of Econometrica might lead you to
believe. Carefully applied to coherent causal questions, regression and
2SLS almost always make sense. Your standard errors probably won’t
be quite right, but they rarely are. Avoid embarrasment by being your
own best skeptic, and especially, DON’T PANIC!”
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Course Material Week 7
I Slides
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Background Material Week 7
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Q&A
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