Chapter 1

Introduction

c Chris Brooks 2013

‘Introductory Econometrics for Finance’ 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.

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 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.

c Chris Brooks 2013

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 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.

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 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”.

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 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

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 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 New York Stock
Exchange
– A sample of bond credit ratings for UK banks

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 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.

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 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.

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 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.
c Chris Brooks 2013
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 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 US 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.

c Chris Brooks 2013

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 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

Rt = pt p−p t−1
t−1
∗ 100% pt
Rt = ln pt−1 ∗ 100%
where, Rt denotes the return at time t, Pt denotes the asset
price at time t and 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.

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 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

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 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:

X
N
Rpt = wi Rit
i =1

• But this does not work for the continuously compounded

returns.

c Chris Brooks 2013

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 Real Versus Nominal Series
• The general level of prices has a tendency to rise most of the
time because of inflation

• We may wish to transform nominal series into real ones to

adjust them for inflation

• This is called deflating a series or displaying a series at

constant prices

• We do this by taking the nominal series and dividing it by a

price deflator:
real seriest = nominal seriest ∗ 100/deflatort
(assuming that the base figure is 100)

• We only deflate series that are in nominal price terms, not

quantity terms.

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 Deflating a Series

• If we wanted to convert a series into a particular year’s figures

(e.g. house prices in 2010 figures), we would use:
real seriest = nominal seriest ∗ deflatorreference year /deflatort

• This is the same equation as the previous slide except with

the deflator for the reference year replacing the assumed
deflator base figure of 100

• Often the consumer price index, CPI, is used as the deflator

series.

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 Steps involved in the formulation of econometric
models
1a. Economic or financial theory (previous studies)

1b. Formulation of an estimable theoretical model

2. Collection of data

3. Model estimation

4. Is the model statistically adequate?

No Yes

Reformulate model 5. Interpret model

6. Use for analysis

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 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 been conducted for violations of any assumptions made
in the estimation of the model been conducted?

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 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?

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 Bayesian versus Classical Statistics
• The philosophical approach to model-building used here
throughout is based on ‘classical statistics’
• This involves postulating a theory and then setting up a
model and collecting data to test that theory
• Based on the results from the model, the theory is supported
or refuted
• There is, however, an entirely different approach known as
Bayesian statistics
• Here, the theory and model are developed together
• The researcher starts with an assessment of existing knowledge
or beliefs formulated as probabilities, known as priors
• The priors are combined with the data into a model

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 Bayesian versus Classical Statistics (Cont’d)
• The beliefs are then updated after estimating the model to
form a set of posterior probabilities
• Bayesian statistics is a well established and popular approach,
although less so than the classical one
• Some classical researchers are uncomfortable with the
Bayesian use of prior probabilities based on judgement
• If the priors are very strong, a great deal of evidence from the
data would be required to overturn them
• So the researcher would end up with the conclusions that
he/she wanted in the first place!
• In the classical case by contrast, judgement is not supposed to
enter the process and thus it is argued to be more objective.

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