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Econometrics For Finace Lecture I

The document provides an overview of econometrics, defining it as the measurement of economic relationships through the integration of economic theory, statistics, and mathematical economics. It discusses the application of econometrics in finance, including modeling, forecasting, and testing financial theories, while distinguishing between financial and economic data. Additionally, it outlines the methodology of econometrics, including model specification, data collection, estimation, hypothesis testing, and the desirable properties of econometric models.

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0% found this document useful (0 votes)
18 views36 pages

Econometrics For Finace Lecture I

The document provides an overview of econometrics, defining it as the measurement of economic relationships through the integration of economic theory, statistics, and mathematical economics. It discusses the application of econometrics in finance, including modeling, forecasting, and testing financial theories, while distinguishing between financial and economic data. Additionally, it outlines the methodology of econometrics, including model specification, data collection, estimation, hypothesis testing, and the desirable properties of econometric models.

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LECTURE I

By:

Amsalu B. (MSc.)

Lecturer, Department of Economics

Unity University

Email: [email protected]

Unity, Addis Ababa, Ethiopia


Definition and Scope of Econometrics
 Econometrics means “economic measurement”
 Measurement is an important aspect of econometrics. Yet, the
scope of econometrics is much broader than measurement.
 Econometrics is basically concerned with measuring of
economic relationships.
 Econometrics is the science which integrates:
 Economic theory
 Economic statistics, and
 Mathematical economics to investigate or provide
numerical values to the parameters of economic
relationships.
What is Econometrics For Finance?
 Econometrics For Finance is:
 A branch of financial economics in the field of economics.
 The application of statistical methods to the
financial market data.
 The application of mathematical techniques to solve the
problems in finance.
 The science of modeling and forecasting financial data.
 Econometrics for finance can be useful for:
 Testing theories in finance, and determining asset prices or
returns, risk management, portfolio allocation,
volatility estimation, etc.
Cont’d
 Testing hypotheses concerning the r/n ships b/n variables
 Examining the effect on financial markets of changes in
economic conditions on financial markets
 Forecasting future values of financial variables for financial
decision-making among others.
 The focusing areas of econometrics for finance includes:
 Capital markets
 Financial institutions
 Corporate finance and corporate governance.
 Econometrics for finance revolve around asset valuation of
individual stocks, bonds, currencies and other financial
instruments.
Is financial econometrics d/t from economic econometrics?
 Financial data often differ from economic data in terms of their
frequency, accuracy, seasonality and other properties.
 In economics, a serious problem is often lack of data at hand for testing
the theory or hypothesis.
 Financial data (variables) are recorded at the spot where trades actually
took place or are quoted on the screens of information providers.
 Financial variables includes revenue, expenses, net income, assets,
liabilities, equity, profit margin, debt-to-equity ratio, current ratio, return on
equity, earnings per share, price-to-earnings ratio, asset turnover, operating
margin, gross margin, cash flow, cost of goods sold, interest expense,
depreciation, and market capitalization; essentially, any measurable aspect
of a company's financial performance that can be derived from its balance
sheet and income statement.
What is a Model?
 A model is a simplified representation of a real-world process.
 The first task in econometrics is that of formulating an
econometric model.
 Financial model is the science of forecasting financial data
such as asset prices, asset returns, interest rates, financial
ratios, etc.
 For instance, ‘the amount of saving depends on income’ is
a simplified representation since there are a host of other
variables that one can think of that determine saving.
Economic Models and Econometric Models
 Economic Models: is a theoretical construct representing
economic processes by a set of variables and a set of logical
and/or quantitative relationships between them.
 Economic models consist of the following three basic
structural elements.
 A set of variables
 A list of fundamental relationships
 A number of strategic coefficients
 For instance, the economic theory postulates that the demand
for a commodity depends on its price, the prices of other
related commodities, consumers’ income and tastes.
Cont’d

 The exact relationship between demand function and its


determinant can be written mathematically as:

 This demand equation is exact and shows relationships


between economic variables.
 Where:
 Q is quantity demand, P is price, Po is the prices of other
related commodities, Y is consumers’ income and t is tastes
and preference of the consumer, bo is intercept and b1 b2 b3
and b4 is slope
Cont’d
 Econometrics Model: are statistical models used in econometrics.
 It contains a random element which is ignored by mathematical
economic models which postulate exact relationships between
economic variables.
 So, the demand function studied with the tools of econometrics
would be of the stochastic form:

 Where u stands for the random factors or disturbance term which


affect the quantity demanded.
 The disturbance term may well represent all those factors or
variables that affect demand but are not well taken into account
exactly by the mathematical model.
Econometrics vs. Mathematical economics
 Mathematical economics: express the economic relationships
in an exact or deterministic form and it doesn’t allows for
random elements which might affect the relationship and
make it stochastic.
 The main concern of mathematical economics is to express
economic theory in mathematical form without regard to
measurability or empirical verification of the theory.
 For example: Economic theory postulates that the demand for
a commodity (Q) depends on its price (P), on the prices of
other related commodities (P0), on consumers’ income (Y) and
on tastes (t).
Econometrics and Statistics
 Statistics is the field concerned with collecting, analyzing,
interpreting, and presenting data.
 The economic statistics is a descriptive aspect of economics.
 Econometric is the uses of statistical theory and mathematical
statistics to evaluate and develop econometric methods.
 Econometrics is the application of statistical methods to topics
in economics.
 Econometric methods are adjusted so that they may become
appropriate for the measurement of economic relationships
which are stochastic.
Methodology of Econometrics
 Econometric research is concerned with the measurement of
the parameters of economic relationships and with the
predication of the values of economic variables.
 The relationships of economic theory which can be measured
with econometric techniques are relationships in which some
variables are postulated as causes of the variation of other
variables.
 Starting with the postulated theoretical relationships among
economic variables, econometric research or inquiry generally
proceeds along the following lines/stages.
Cont’d
 Statement of theory or hypothesis:
 To illustrate the preceding steps, let us consider the well-
known Keynesian theory of consumption.
 Keynes states that on average, consumers increase their
consumption as their income increases, but not as much
as the increase in their income.
 It means that “the marginal propensity to consume
(MPC) for a unit change in income is grater than zero
but less than unit”
Cont’d
 Specification of the model: Y = ß1+ ß2X ; 0 < ß2< 1
 Y = consumption expenditure (dependent variable)
 X = income (independent or explanatory variable)
 ß1 and ß2 are parameters, and ß1 is intercept, and
 ß2 is slope coefficients measures the MPC.
Cont’d
 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 affect consumption
but not included.
 To allow for the inexact relationships between economic
variables, the mathematical equation is modified as follows:
Y = ß1+ ß2X + u ; 0 < ß2< 1
Cont’d
 The inexact relationships between economic variables are
captured by the disturbance term or error term (u).
 Where u, known as the disturbance, or error, term, is a random
(stochastic) variable that has well-defined probabilistic properties.
Cont’d
 Obtaining Data: An econometric model requires data on all the variables
in the model. To obtain the numerical values of β1 and β2, we need data such
as in table 1.1, which relate to the personal consumption expenditure
(PCE) and the gross domestic product (GDP).
Cont’d
 Estimating the Econometric Model:
 Regression analysis: the estimated consumption function is:

 The regression line fits the data quite well; since MPC is 0.70;
increase in real income of 1 birr led, on average, to an increase of
about 70 percents in real consumption.
 Note: A hat symbol (^) above one variable will signify an
estimator of the relevant population value
Cont’d
 The estimated regression line is
Cont’d
 Hypothesis Testing: is a tool for making statistical inferences
about the population data.
 It provides a way to verify whether the results of an experiment
are valid.
 Keynes postulated the MPC to be positive but less than 1.
 The MPC to be about 0.70. But before we accept the MPC = 0.70
as confirmation of Keynesian consumption theory, we must
enquire whether this estimate is sufficiently below unity.
 Such confirmation or refutation of economic theories on the
basis of sample evidence is called as statistical inference
(hypothesis testing).
Cont’d
 Forecasting or Prediction: is an estimation of a future
events. That means, With given future value(s) of X, what is
the future value(s) of Y?
 Suppose, we want to predict the mean consumption
expenditure for 1997. The GDP value for 1997 was 7269.8 billion
birr, consumption would be: Yˆ1997 = 184.0779 + 0.7064
(7269.8) = 5319.5. However, the actual value of the consumption
expenditure reported in 1997 was 5313.5 billion birr.
Cont’d
 Using model for control or policy purposes: Suppose further the
government believes that consumer expenditure of about 4,900 will
keep the unemployment rate at its current level of about 4.2%. What
level of income will guarantee the target amount of consumption
expenditure?
 Simple arithmetic will show that: 4,900 = 184.0779 + 0.7064X.
 X = 6,675, approximately. An income level of about 6675 (billion)
birr, given an MPC of about 0.70, will produce an expenditure of
about 4,900 billion birr.
 By appropriate fiscal and monetary policy mix, the government can
manipulate the control variable X to produce the desired level of the
target variable Y.
Desirable Properties of an Econometric Model
 An econometric model is a model whose parameters have
been estimated with some appropriate econometric technique.
 The ‘goodness’ of an econometric model is judged customarily
according to the following desirable properties.
 Theoretical plausibility: The model should be compatible
with the postulates of economic theory. It must describe
adequately the economic phenomena to which it relates.
 Explanatory ability: The model should be able to explain the
observations of the actual world. It must be consistent with the
observed behavior of the economic variables whose relationship
it determines.
Cont’d
 Accuracy of the estimates of the parameters: The estimates
of the coefficients should be accurate in the sense that they
should approximate as best as possible the true parameters of
the structural model.
 The estimates should if possible possess the desirable properties
of unbiasedness, consistency and efficiency.
 Forecasting ability: The model should produce satisfactory
predictions of future values of the dependent (endogenous)
variables.
Cont’d
 Simplicity: The model should represent the economic
relationships with maximum simplicity.
 The fewer the equations and the simpler their mathematical
form, the better the model is considered, ceteris paribus (that is
to say provided that the other desirable properties are not
affected by the simplifications of the model)
1.4. The Goals or Purpose of Econometrics
 Econometrics help us to achieves the following three
goals:
 Analysis: Judge the validity of the economic theories.
 Policy making: Supply the numerical estimates of the
coefficient of the economic relationships which may be then
used for some sound economic policies.
 Forecasting: Forecast the future values of the economic
magnitude with certain degree of probability.
Econometric Types of Data
 Time series data: a time series data set consists of observations
on a variable or several variables over time.
 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
 Examples of time series data include stock prices, money
supply, consumer price index, gross domestic product, and
automobile sales figures.
 Because past events can influence future events and lags in
behavior are prevalent in the social sciences, time is an important
dimension in time series data set.
Cont’d

 Time series data on minimum wages and related variables

Time series observations are typically serially correlated.

Average minimum Average Unemployment Gross national


wage for given year coverage rate rate product
Cross-sectional data sets
 In cross-section data, values of one or more variables are
collected for several sample units, or entities, at the same
point in time.
 Sample of individuals, households, firms, cities, states,
countries, or other units of interest at a given point of
time/in a given period.
 The observations are more or less independent
 The data typically encountered in applied microeconomics
Cont’d
Cont’d
Pooled Cross Sections
 Pooled cross-sectional data or observations collected over
time, but the units don’t have to be the same.
 The elements of both time series and cross sectional data.
 Two or more cross sections are combined in one data set
and the cross sections are drawn independently of each other
 They record the behavior of the same set of individual
microeconomic units over time.
 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)
Cont’d
 Pooled cross sections on housing prices

Property tax
Size of house
in square feet

Number of bathrooms

Before reform

After reform
Panel or Longitudinal Data
 The data are also called micro panel data is a special type of
pooled data in which the same cross-sectional unit (say, a
family or a firm) is surveyed over time.
 Panel data have space as well as time dimensions.
 There are other names for panel data, such as pooled data (time
series and cross-sectional data), combination of time series and
cross-section data, micro panel data, longitudinal data (a study
over time of a variable or group of subjects), event history
analysis (studying the movement over time of subjects through
successive states or conditions), cohort analysis (following the
career path of 1965 graduates of a business school).
Cont’d
 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.

 Two-year panel data on city crime statistics are:

Each city has two time


series observations

Number of
police in 1986

Number of
police in 1990
THANKS!!!

THE OF END LECTURE ONE!!!

THANKS!!!

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