Understanding Financial

Econometrics
The concept of Fin. Econometrics
Introduction to Financial Data
 Introduction
The Concept of Financial econometrics
• It is the application of statistical techniques to problems in finance.
• Defined as the application of statistical methods to financial market data.
Financial econometrics is a branch of financial economics, in the field of
economics. Areas of study include capital markets, financial institutions,
corporate finance and corporate governance. Topics often revolve around
asset valuation of individual stocks, bonds, derivatives, currencies and
other financial instruments.
• Financial econometrics is different from other forms of econometrics
because the emphasis is usually on analyzing the prices of financial assets
traded at competitive, liquid markets. People working in the finance
industry or researching the finance sector often use econometric
techniques in a range of activities-for example, in support of portfolio
management and in the valuation of securities.
The Concept of Financial econometrics
Cont’s
• Financial econometrics is essential for risk management when it is
important to know how often 'bad' investment outcomes are
expected to occur over future days, weeks, months and years.
• It is also useful for testing theories in finance, determining asset
prices or returns, testing hypotheses concerning the relationships
between variables, examining the effect on financial markets of
changes in economic conditions, forecasting future values of financial
variables and for financial decision-making.
• See overleaf for more examples of the uses of financial
econometrics
Examples of the uses of Fin. Econometrics

(1) Testing whether financial markets are weak-form informationally efficient.

(2) Testing whether the capital asset pricing model (CAPM) or arbitrage
pricing theory (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 uses of Fin. Econometrics Cont’s

(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 stock indices of two countries.
Is financial econometrics different from
‘economic econometrics’?
• The tools commonly used in financial applications are fundamentally the same as
those used in economic applications, although the emphasis and the sets of
problems that are likely to be encountered when analysing the two sets of data are
somewhat different.
• Financial data often differ from macroeconomic data in terms of their frequency,
accuracy, seasonality and other properties.
• Issues of lack of data at hand, measurement error and data revisions are more
prevalent in economic data than financial data.
• Financial data come in many shapes and forms, but in general the prices and other
entities that are recorded are those at which trades actually took place, or which
were quoted on the screens of information providers.
• Similarly, some sets of financial data are observed at much higher frequencies than
macroeconomic data, for e.g, asset prices or yields are often available at daily,
hourly or minute-by-minute frequencies.
 Group Work Question 1 ( Michael)
1) Discuss the limitations of Financial data in building an econometric
model. [10 marks]
2) Explain in detail the major differences between financial
econometrics and general (economic) econometrics [9 marks]
 Types of data
• There are broadly three types of data that can be employed in
quantitative analysis of financial problems: time series data,
cross-sectional data and panel data.

Time Series Data

• Data that have been collected over a period of time on one or more
variables.
• Time series data have associated with them a particular frequency of
observation or frequency of collection of data points.
• The frequency is simply a measure of the interval over, or the
regularity with which, the data are collected or recorded
 Types of Data Cont’s
Examples of time series data include stock prices (daily/
weekly/monthly/annually), Industrial Production (monthly/quarterly),
money supply (monthly/annual), consumer price index
(weekly/monthly/annually), gross domestic product (Annually), Annual
homicide rates (daily/weekly/monthly/annually), and automobile sales
figures (daily/ weekly/monthly/annually).
• Because past events can influence future events and lags in behaviour
are prevalent in the social sciences, time is an important dimension in
a time series data set.
• Unlike the arrangement of cross-sectional data, the chronological
ordering of observations in a time series conveys potentially
important information.
 Types of Data Cont’s
Cross-Sectional Data
• The set consists of a sample of individuals, households, firms, cities, states,
countries, or a variety of other units, taken at a given point in time.
• Alternatively, it is the data on one or more variables collected at a single
point in time.
• For example, the data might be on: A poll of usage of internet stockbroking
services; A cross-section of stock returns on the Zimbabwe Stock Exchange
(ZSE); A sample of bond credit ratings for Zimbabwean banks.
• In a pure cross-sectional analysis, we would ignore any minor timing
differences in collecting the data. If a set of families was surveyed during
different weeks of the same year, we would still view this as a
cross-sectional data set.
 Types of Data Cont’s
Panel or Longitudinal Data
• A set that consists of a time series for each cross-sectional member in the data
set. As an example, suppose we have wage, education, and employment history
for a set of individuals followed over a ten-year period.
• It can also be the daily prices of a number of blue chip stocks over two years.
• Or we might collect information, such as investment and financial data, about the
same set of firms over a five-year time period. Panel data can also be collected on
geographical units.
• For example, we can collect data for the same set of variables in the United States
on immigration flows, tax rates, wage rates, government expenditures, Current
account and so on, for the years 1985, 1990 and 1995.
 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 dividend yield on a stock could be 6.2%, 6.24% or
6.238%, and so on.
• On the other hand, discrete data can only take on certain values, which
are usually integers (whole numbers), and are often defined to be count
numbers.
• For instance, the number of shares traded during a day. In these cases,
having 5857.5 shares traded would not make sense.
• The simplest example of a discrete variable is a Bernoulli or binary
random variable, which can only take the values 0 or 1 - for example, if
we repeatedly tossed a coin, we could denote a head by 0 and a tail by 1.
Cardinal, Ordinal and Nominal numbers
Group Question 2(Group 1-Michael)
• With reference to practical examples, explain the following:
(1) Cardinal numbers,
(2) Ordinal numbers and
(3) Nominal numbers
 Returns in Fin. Modelling
• In many of the problems of interest in finance, the starting point is a
time series of prices, for e.g, the price of an comet share taken at
1630hrs daily for 500 days.
• For a number of statistical reasons, it is preferable not to work
directly with the price series, so raw price series are usually converted
into series of returns.
• There are two methods used to calculate returns from a series of
prices, and these involve the formation of simple returns, and
continuously compounded returns, which are achieved as follows:
Returns in Fin. Modelling Cont’s
•
Steps involved in forming an fin.econometric
model
Steps involved in forming an fin.econometric model
Cont’s
Step 1a and 1b: General statement of the problem
• This will usually involve the formulation of a theoretical model, or intuition
from financial theory that two or more variables should be related to one
another in a certain way.
• The model is unlikely to be able to completely capture every relevant
real-world phenomenon, but it should present a sufficiently good
approximation that it is useful for the purpose at hand.
Step 2: Collection of data relevant to the model
• The data required may be available electronically through a financial
information provider, such as Reuters or from published government figures.
• Alternatively, the required data may be available only via a survey after
distributing a set of questionnaires, i.e., primary data.
 Steps involved in forming an fin.econometric
model Cont’s
Step 3: Choice of estimation method relevant to the model proposed in step 1
• For example, is a single equation or multiple equation technique to be used?
Step 4: Statistical evaluation of the model
• What assumptions were required to estimate the parameters of the model
optimally? Were these assumptions satisfied by the data or the model? Also,
does the model adequately describe the data? If the answer is ‘yes’, proceed to
step 5; if not, go back to steps 1–3 and either reformulate the model, collect
more data, or select a different estimation technique that has less stringent
requirements.
Step 5: Evaluation of the model from a theoretical perspective
• Are the parameter estimates of the sizes and signs that the theory or intuition
from step 1 suggested?
• If the answer is ‘yes’, proceed to step 6; if not, again return to stages 1–3.
 Step 6: Use of model
• When a researcher is finally satisfied with the model, it can then be used
for testing the theory specified in step 1, or for formulating forecasts or
suggested courses of action.
• This suggested course of action might be for an individual (e.g. ‘if inflation
and GDP rise, buy stocks in sector X’), or as an input to government policy
(e.g. ‘when equity markets fall, program trading causes excessive volatility
and so should be banned’).
NB: It is important to note that the process of building a robust empirical
model is an iterative one, and it is certainly not an exact science. Often, the
final preferred model could be very different from the one originally
proposed, and need not be unique in the sense that another researcher with
the same data and the same initial theory could arrive at a different final
specification.